Some investors appear to be, as per the old adage, ‘picking up pennies in front of a steamroller’.
When investing in credit markets, the spread earned over the risk-free rate is always predicated on taking some level of risk.
But in the case of US high yield bonds today, we don’t think investors are being compensated accordingly.
They are clipping ever-smaller coupons, while the limited scope for yields to fall means they won’t even be able to sell their holdings to a ‘greater fool’ for a higher price.
All the while, the spectre of a high-yield ‘blow-up’ - that proverbial steamroller - looms increasingly large in the background.
This reward for owning high yield bonds has not been meaningfully lower since the Financial Crisis.
Conversely, in several growth scares since 2009, this ‘spread’ has risen to nearly double the current level, or more, subjecting holders to a large capital loss.
Such market complacency is not justified.
Outlook
Fundamentals and bondholder protections are deteriorating, and America’s economic outlook continues to weaken, with business surveys still subdued after a year of near-zero earnings growth.
This reward for owning high yield bonds has not been meaningfully lower since the Financial Crisis.The underlying sector exposures in the US high yield universe compounds such vulnerabilities.
The market is even crimped by negative convexity, whereby further appreciation is effectively capped by the many bonds in the universe being ‘callable’ by issuers should prices rise high enough. And it’s not like investors have no alternative.
We have seen US growth continue to slow - ‘catching down’ to the rest of the world - after a period of strong outperformance prior to last year.
While the ‘trade war’ may now be on the back-burner, Bernie Sanders uncertainty could lie ahead as we approach the election.
Fundamentals and bondholder protections are deteriorating.On the positive side of the ledger, the housing sector is well above trend after being supported by a dovish Fed via lower rates in 2019.
But for the US high yield market, strength in real estate is of little solace especially compared to the more vulnerable ‘consumer sensitives’ of consumer goods, retail, leisure, and media, which together comprise nearly a quarter of the US high yield universe.
We have seen a number of mounting headwinds for the US consumer sector; retail sales have been flat for six months now, aggregate hours worked in the economy are struggling to grow as the labour market hits capacity, wages are eating into profit margins, and retail junk-bond borrowers continue to face pressure from ‘Amazon-ification’.
The US high yield market is also experiencing negative convexity.Risks
Another 12 per cent or so of the US high yield market is in energy.
Even looking through the coronavirus impact that has seen oil demand and prices plunge, we see a US shale oil industry where the ability to turn an economic profit outside the mega-cap Oil Majors is being severely questioned.
We see risks to the entire fracking industry should a progressive Democratic candidate be elected president. And on that point, the market’s equally-large healthcare exposure looks like an inevitable target should a Democrat displace Donald.
The US high yield market is also experiencing negative convexity.
This means that any future price appreciation is significantly capped as investors face companies who have issued callable bonds, which effectively means that issuers can refinance at more favourable rates should yields fall far enough.
And fall they have; over half of the index comprises bonds now trading above the next call price.
As the chart shows, the spread between the Bloomberg Barclays US Corporate High Yield Index’s yield-to-maturity and yield-to-worst is touching post-crisis highs again.
Betting against the S&P 500 and its fashionable technology behemoths, which continue to drive market returns, remains a bold call.Therefore, the days of exceptional price returns driving performance in the market appears to be behind us. Indeed, such an environment has been associated with outright negative price returns over the next twelve months.
Source: Bloomberg as at 24 February 2020
Changing tack
Many investors have been tempted, and burned, by avoiding expensive US equities.
But at least here, ‘high risk, high reward’ may still hold.
Betting against the S&P 500 and its fashionable technology behemoths, which continue to drive market returns, remains a bold call - even if parallels to the ‘dot com bubble’ justifiably ring alarm bells.
If investors want a ‘safer’ and more direct way of avoiding downside risks in the US economy, reducing high-yield exposure is likely the more prudent trade.
The risk of missing out on gains is smaller, but the market downside is just as apparent.
The global reach-for-yield has reached a fever-pitch, and this extends into government bonds too.
Even Italy’s recent 15-year BTP issue was more than five times oversubscribed and priced below 1.5 per cent.
Despite this, unappealing investments are not an inevitable fact of life; for example, some emerging market government debt, issued in dollars, provide a relatively attractive proposition.
At times like this, investors can be tempted indiscriminately down the capital structure into assets like high yield debt - but for investors, getting the risk-reward profile skewed in your favour is perennially important.
Ian Samson is an assistant portfolio manager at Fidelity International
