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High yield disconnected

Kris Xippolitos

By Kris Xippolitos

Head - Fixed Income Strategy

November 27, 2017Posted InInvestments, Fixed Income and Investment Strategy

Over the last several weeks, US high yield bond spreads have steadily moved wider. Since reaching its tightest levels since 2007 in late October, index spreads (to US Treasury debt) have gapped out 50 basis points (bp) to roughly 380bp. Yields also spiked 65bp to near 6.0%, its highest level since March 2017.

Staying true to form, news headlines about the demise of the high yield bond market have appeared in masses. Of course, this reaction is similar to what we witnessed last March and then subsequently again in August, when spreads also widened sharply. In both instances, spreads ultimately regained momentum and resumed its trend toward tighter levels. We believe this time around isn’t any different.

 

Figure 1: Cumulative High Yield Energy and Telecom Total Return Since Jun 1

 

Source: The YieldBook as of November 15, 2017.

 

The recent sell-off in high yield largely stemmed from two occurrences (Figure 1). Primarily, negative idiosyncratic events from several large HY issuers played a significant role in moving overall benchmark valuations. For example, certain bonds issued by the wireless telecommunication company, Sprint Corp, dropped 12-13 points after merger negotiations with T-Mobile collapsed. Sprint (rated B3/B) is one of the high yield market’s largest issuers, with $25 billion in outstanding bonds (or 2.0% of the high yield benchmark). The drop in bond prices reduced the market value of Sprints existing bonds by nearly $3 billion.

European cable provider, Altice (also 2.0% of high yield index), saw their bonds fall 3-6 points on reduced earnings guidance. iHeartMedia (1.0% of index), CenturyLink (1.2% of index) and Community Health (0.8% of index), are other relatively large high yield issuers, whose bond prices also dropped meaningfully from disappointing earnings results. Indeed, these issuer-specific events have weighed heavily on overall index spreads. That said, the rest of the high yield market has been left relatively unscathed. This is very similar to the market reaction in early 2016, when the energy sector collapsed along with falling oil prices. During that period, non-energy related sectors were much less affected.

That said, the rest of the high yield market has been left relatively unscathed. This is very similar to the market reaction in early 2016, when the energy sector collapsed along with falling oil prices. During that period, non-energy related sectors were much less affected. Though somewhat ironic that energy could be considered a defensive high yield sector today, we believe this continues to highlight the importance of selectivity. Unfortunately, passive exchange-traded funds (ETFs) do not offer investors the flexibility to navigate concentration risks, or avoid indiscriminate selling, like we’ve seen over the last several weeks.

High yield investors are also digesting potential impacts from certain provisions in the proposed US tax reform bill. More specifically, the limitations a corporation may have in their ability to deduct interest expenses from taxable income (this was included in both the House of Representatives and Senate versions). On the surface, this should negatively affect highly leveraged companies who rely on these tax deductions to improve their overall credit health. In our view, even if included in the final bill, we believe its effects have been overstated. 

A few things to consider: One – the low yield environment has allowed high yield issuers to refinance higher coupon debt, improving their ability to service future interest payments. Indeed, average high yield coupons are at all-time lows (Figure 2). This implies interest deductibility may not be as meaningful when compare to past cycles.

Two – what a high yield issuer loses in their ability to deduct interest, could very well gain in profits from the reduction in the corporate tax rate to 20%.Though likely not dollar-for-dollar, we can assume some added benefit taxes.

Three – high yield companies with negative free-cash-flow could be less impacted, as these issuers may benefit more from writing-off accumulated negative operating losses.

Four – also consider what’s described in the House bill as “carry forward of disallowed interest”. This will allow a corporation the ability to carryforward any remaining interest expense over the following five years.

 

Figure 2: US High Yield Coupons are at Historic Lows

 

Source: The YieldBook as of November 15, 2017

 

Undoubtedly, the entire high yield market won’t likely escape untouched. Certain troubled companies will likely suffer from their inability to deduct interest. Cost of capital can rise at the margins, though fundamentals will ultimately matter more. Other issuers that face a heightened level of risk are those created through leveraged buy-outs, where debt levels are typically high. As we’ve mentioned repeatedly, market returns going forward in US high yield will likely be more challenging.

Despite strong fundamentals, high valuations can create periods of investor nervousness and fuel outflows (especially in passive investments). Still, default rates are falling and attractive yield opportunities elsewhere are few and far between. Earnings growth should remain supportive for equity markets, and correlations to high yield bonds are high. Though we expect developed market yields to rise, this will likely have a more adverse impact on higher quality, investment grade fixed income. Though returns may be less than stellar, US high yield is still expected to be a relative fixed income outperformer over the coming year.

 

Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.