Justifying High Yield Valuations
Garrett Cargin, CFA
High Yield (HY) has been a top pick at the GFICC Investment Quarterly (IQ) for three consecutive quarters despite yields near all-time lows and spreads through cycle tights since mid-June. While technicals can drive valuations over the short-term, long-term valuations reflect underlying fundamentals. With valuations seemingly expensive, we have identified three fundamental reasons why the asset class remains attractive relative to its fixed income peers.
Low Default Environment Likely to Persist
Following the flood of defaults that occurred as a result of the COVID-19 pandemic, there have been very few HY defaults YTD 2021, with 7 companies defaulting, for a total of $4.1bn, the lightest stretch since before the Global Financial Crisis (GFC). With the HY market at its all-time largest size, $1.6T, the result is a trailing twelve month default rate of 0.92%, which is approaching post GFC lows.
Furthermore, distressed debt (bonds trading below $70) in the market is also near all-time lows. As one would expect, distressed debt has historically been a strong indicator of future defaults, and consequently market consensus is that the default rate will remain well below the long term median of 2.06% through 2022. To put that into perspective, assume that the market experiences the same level of defaults over the next 12 months as it did over the previous 12 months, or roughly 1%, the HY market would provide 273 basis points (bps) of excess return (assuming a 40% recovery rate), in line with historical levels despite the current Spread to Worst (STW) of 333bps. Recall that Excess Spread = STW – (Default Rate * (1 - Recovery Rate)).
In most HY markets, distressed debt also provides a disproportionate amount of spread to the overall market that is often not realized should those credits default. On average over the past five years, the market value of issuers trading wide of 1,000bps was 4.8%, yet those issuers contribute to 20.1% of the market’s overall STW. This component currently accounts for only 1.6% of market value and contributes 8.2% of the market’s STW, or 27bps. This compares to 99bps at 12/31/19 and 43bps at 10/3/18, the previous cycle tight. The limited contribution from distressed issuers is largely due to the ‘pull forward’ in defaults experienced in 2020 and is evident of a higher quality HY market.
Improved Credit Quality in HY
2020 set the record for Fallen Angels, as over $230bn of formerly investment grade (IG) bonds entered the index and the high default rate cleansed the market of its weakest credits. These factors have resulted in the highest quality HY market in history, as approximately 54% of the market is rated BB despite the fact that 50% of the HY market was downgraded in 2020; conversely, more than 65% of that cohort has been upgraded thus far in 2021. While the HY market is at the highest quality it has ever been, it is worth noting that the market is now more cyclical as the majority of Fallen Angels were in COVID-19 impacted sectors, specifically consumer cyclicals and energy. With most market participants anticipating Rising Star volume to surpass $200bn by the end of 2022, the HY market is likely peaking in terms of credit quality and will abate to more historical averages over time.
Strong Credit Environment
Due to the aforementioned reasons as well as the “V” shaped recovery, which was catalyzed by the re-opening trade and historic levels of fiscal and monetary stimulus, HY corporate fundamentals are perhaps at their strongest levels. Most issuers are expected to outperform full year 2019 earnings on both a revenue and EBITDA basis, deleveraging companies to below pre-COVID levels. High yield issuers have exhibited excellent balance sheet discipline since 1Q20, but we expect issuers to begin making capital allocation decisions that become more balanced between debt and equity holders. Supply chain challenges and labor / wage pressures will impact roughly half of the HY market, but these issues will erode margins from extremely high levels and we believe will impact equity valuations more than credit valuations.
A strong US economy and limited default risk bode well for HY nominal returns, while its shorter duration and higher spread offer attractive relative value vs higher quality fixed income in a rising rate environment. We believe spreads will be range bound over the next 3-6 months: spreads could tighten if rates rise at a measured pace and could widen on worrisome 3Q21 earnings or poor Federal Reserve execution. High Yield has experienced sustained periods of tight spreads and low defaults, an environment we believe we are in, and produced ‘carry-like’ returns over those periods.
In summary, the HY market is fairly valued despite tight spread levels and low yields. The lower starting U.S. Treasury yield, relative to the shaded periods above, may dampen nominal returns but likely elevate excess and relative returns. The HY market stands on solid fundamental footing that justifies current valuations. Although current ‘carry’ of 4% may seem meager by historical standards, it is attractive in the post-GFC rate era.