Given the deluge of macro worries raining down on markets at present, it is perhaps all the more impressive that high-yield bond spreads continue to grind tighter.
A wave of poor macro data in the US, political wrangling in eastern Europe, a downward lurch in the renminbi, potential corporate default in China and the threat of deflation in the eurozone have all failed to stop high-yield spreads from breaching post-credit crisis lows. At 441 basis points above US Treasuries the spread on the JPMorgan Global High Yield index is now back to levels not seen since October 2007.
Inherently a risk asset, the continued tightening of spreads may therefore seem odd. However, the bigger picture remains a world of low inflation and accelerating economic growth – the idyllic mix for high yield.
Default rates are running at less than 2 per cent and with the bulk of issuance over the past five years being used for refinancing, the maturity wall has been extended out materially. Given the healthy underlying fundamentals, we do not expect the next pick up in the default rate cycle to surface until late 2015 or early 2016.
The technical picture also remains supportive. With central banks embarked on financial repression, interest rates are at rock bottom and there remains an insatiable thirst for yield. So in spite of the current worst-case scenario indicator, ‘yield to worst’ of the high-yield index, standing at just 5.6 per cent, very close to all-time lows, there is still strong demand given the headline yield relative to other parts of the fixed income markets.
It is no surprise then that money continues to pour into the asset class. A short-term positive no doubt, but perhaps a longer term concern. While the high yield market is not as white hot as the leveraged loan market, it is undoubtedly a widely-owned asset class.
A recent letter from the Securities and Exchange Commission in the US to fund houses highlights that assets in high-yield bond funds and exchange-traded funds have exploded in recent years at a time when inventory on brokers’ balance sheets has diminished. In other words, they are concerned about liquidity when the herd rushes for the exit. This could apply to any number of asset classes.
For us, high yield is certainly not an asset class to own across the cycle. There are times where we will want to have a zero allocation in our portfolios in spite of the longer term attractive risk/return characteristics of the asset class.
However, in spite of the stellar performance of high yield we are not there yet. Current spreads still stand above the median spreads observed in 2004-2006 and significantly above the all time lows. Credit quality is better than it was in that period and even after building in a liquidity premium we still believe there is value left.
But with some initial warning signs beginning to flash it has provided an opportunity to both lighten our allocation and refocus on the BB-rated area of the market, which we believe offers greater value.
It’s been a great ride for high-yield investors and the journey is not complete but, as with other illiquid asset classes, investors should look to disembark a couple of stops before the final destination.
Tony Lanning is manager of the JPMorgan Asset Management Fusion funds
