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1) Where are we now? US High Yield trading at 5.7% yield-to-worst
2) The Good: Default rates are lower than expected
3) The Bad: For defaulted bonds, recovery values are at record lows
4) We might be reaching an inflection point
5) What returns should we expect if we invest in High Yield now?
The InvestQuest’s View
While we see stronger fundamentals for the High Yield Bond market, valuations are still unattractive to us at this point. We estimate that High Yield Bond investors should roughly expect 2.9% total returns for a well-diversified portfolio for the year ahead.
To generate a 3% return, we would personally prefer to sell a 1-year put option on the S&P 500, with a strike at 2,500 (26% below the current index level of 3,386). For such a strategy, we would receive the 3% option premium upfront and if the S&P 500 falls below 2,500 in a year’s time, we would be obliged to buy the S&P 500 at 2,500 then.
We recently read a J.P. Morgan Research report titled “Default Monitor: High Yield and Leveraged Loan Research” (published 1 October 2020). It was incredibly useful in helping us frame where we stand with regard to the High Yield Bond market.
IQ’s previous calls on the High Yield Bond market
In April 2020, we turned bullish on High Yield Bonds when credit spreads widened past 8%. By June, we had become much more cautious, as we felt that valuations had run ahead of fundamentals.
You may find our previous articles below for reference:
- 11 April 2020: Is now a good time to buy High Yield Bonds?
- 26 June 2020: Legendary Professor Altman forecasts 9% default rate for US High Yield
For the moment, it seems like the global economy has managed to avoid the worst-case scenario that many organizations had predicted earlier and we too have become less bearish.
That said, is there a case to invest in High Yield Bonds now?
1) Where are we now? US High Yield trading at 5.7% yield-to-worst
Yields for US Corporate High Yield Bonds have declined significantly since March 2020 and now trade at 5.7%. While this is low compared with the 15-year historical average of 7.8%, note that much of this decline has been driven by falling US government bond yields, rather than reduction in credit spreads.
High Yield Credit Spreads of 5.1% currently is near the historical 15-year average of 5.3%. “Credit spreads” refer to the extra yield an investor potential earns from investing in a corporate bond rather than a risk-free government bond. It is used as a valuation metric to know if you are getting paid sufficiently for taking credit risk.
2) The Good: Default rates are lower than expected
Year-to-date as of 30 September 2020, the US recorded US$72.5bn in High Yield Bond defaults (see chart below). This figure amounts to the second highest calendar year on record, and the year isn’t over yet…
That said, default rates are coming in much lower than expected. As of 30 September 2020, the trailing 12-month High Yield default rate stands at 5.8%, above the 2.98% historical 25-year average but below the high-single to low-double digit percentage that many investors had forecasted earlier this year. For reference, the chart below shows the historical US High Yield default rate since 1994.
The outlook for 2021 has also been improving. Just last week, J.P. Morgan had lowered their 2021 expected default rate to 3.5% (from 5% previously).
One way to forecast bond defaults is to look at the amount of High Yield Bonds trading at “distressed prices” (see chart below). A low figure would imply that the market is not pricing in a high probability of large-scale defaults. For now, we are comforted that “US High Yield Bonds trading below 50% of par value” currently amounts to US$26.3bn, approximately 2% of the US$1.5 trillion market.
3) The Bad: For defaulted bonds, recovery values are at record lows
At the moment, our main concern would be on the record low recovery rates for defaulted High Yield Bonds. This year, the recovery rate for defaulted bonds has hit a record low of 15% (meaning that investors got back $0.15 for every $1 of a bond’s face value), vs the 25-year historical average of 40.5%.
While it is unsurprising to see lower recovery rates for defaulted bonds during a downturn, note that recovery rates had already declined to 23% in 2019.
4) We might be reaching an inflection point
We think that the downgrade cycle for High Yield Bonds may be approaching an inflection point. As of 30 September 2020, there have already been US$217.4 billion of new Fallen Angels, the most on record for any calendar year (see chart below).
“Fallen Angels” refer to bonds that had been downgraded to High Yield status from Investment Grade status.
We think that the worst is behind us. Looking at the ratio of High Yield Bond rating upgrades divided by rating downgrades, the current ratio of 0.38 is quite close to the troughs experienced during the previous two recessions in 2001 and 2007-08.
5) What returns should we expect if we invest in High Yield now?
In section 1, we mentioned that US High Yield Bonds trade at 5.7% yield-to-worst now. However, this is not our expected return. We have to factor in three things:
- Expected changes in government bonds yields (the risk-free rate): Lower yields can boost returns, due to price appreciation for bonds.
- Expected changes to credit spreads: Tighter credit spreads can boost returns, due to price appreciation for bonds.
- Expected default losses: Lower default rates and higher recovery values can help minimize expected credit losses.
1) Expected changes in government bonds yields (the risk-free rate)
We think that longer-maturity government yields should rise gradually as long-term growth and inflation expectations pick up. Potential catalysts include an announcement of a successful Covid-19 vaccine and/or a US Democratic clean sweep of the House, Senate and Presidency that increases the likelihood of a larger than expected fiscal stimulus package.
2) Expected changes to credit spreads
We think that High Yield credit spreads will continue to tighten, as more investors adopt a more benign outlook for the rest of 2020 and 2021. A more even distribution of credit rating upgrades and downgrades alongside the above mentioned catalysts may also contribute to tighter credit spreads.
Overall, we think the negative impact from higher government bond yields will offset the positive impact from tighter credit spreads.
3) Expected default losses
Using J.P. Morgan’s latest High Yield Bond default rate forecast of 3.5% for 2021 and conservative recovery rates of 20%, we expect credit losses for 2021 to be 2.8% (3.5% default rate * (100% – 20% recovery rate))
As a result for 2021, the expected total returns for the High Yield Bond market would then be 2.9% (yield-to-worst of 5.7%, minus expected credit losses of 2.8%).
The InvestQuest’s View
While we see stronger fundamentals for the High Yield Bond market, valuations are still unattractive to us at this point. We estimate that High Yield Bond investors should roughly expect 2.9% total returns for a well-diversified portfolio for the year ahead.
To generate a 3% return, we would personally prefer to sell a 1-year put option on the S&P 500, with a strike of 2,500 (26% below the current index level of 3,386). For such a strategy, if the S&P 500 falls below 2,500 in a year’s time, we would be obliged to buy the S&P 500 at 2,500.
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