17 June 2021
Aiming high
We explore why high yield is one of our best ideas following our Global Fixed Income, Currency & Commodities (GFICC) Investment Quarterly meeting last week.
Fundamentals
High yield fundamentals continue to improve as corporates emerge from the pandemic awash with cash. In particular, the seemingly limitless provision of liquidity from central banks, coupled with unprecedented levels of non-wartime fiscal expenditure, has propelled many companies into the “recovery” phase of the credit cycle. As such, credit distress within high yield is low and sporadic. Trailing 12-month default rates currently sit at 2.58% and 3.13% in the US and Europe, respectively, and are set to head lower with annualised run rates expected to reach around 1%. In addition, US high yield defaults had the most modest five-month start to a calendar year since 2011. Moreover, the pace of improvement in credit metrics is accelerating. For example, in US high yield, 1Q 2021 earnings before interest, tax, depreciation and amortization (EBITDA) had the largest increase year on year (YoY) since 2010 (up 23.3%). Similarly, revenues expanded for the first time since 2Q 2019 (up 6.7% YoY). Corporates should naturally de-lever over the coming months, albeit potentially at the expense of more shareholder-friendly activity. Nonetheless, we are mindful of two tail risk scenarios that could disrupt the high yield party. The first is unanticipated inflationary pressures outside the “transitory” realm, thereby resulting in an aggressive withdrawal of central bank support and subsequent recession. The second is prolonged Covid- related demand disruption, although we expect the market to look through temporary Covid setbacks as long as rates remain low. (Data as of 31 May 2021).
Quantitative valuations
While the rates curves in both the US and Europe have moved higher amid more nervousness around inflation so far this year, high yield spreads continue a slow grind tighter. In particular, European high yield spreads, currently at 286 basis points (bps), are establishing new tights year to date, while US spreads, currently at 318 bps, are at lows not seen since 2018. We expect this trend to continue since spreads typically do not widen in periods when default ratings are declining. Although these levels still compensate for both current and forward default rates, high yield valuations do appear expensive to the dedicated high yield investor. Nonetheless, high yield still screens well versus other asset classes for its all-in yield and lower sensitivity to interest rates, which should protect investors from episodic rate volatility over the coming months. (Data as of 11 June 2021).
Spreads typically do not widen in periods when default ratings are declining
Source: J.P. Morgan Asset Management, 12-month rolling monthly data. Default data as of 31 May 2021, spread data as of 15 June 2021.
Technicals
The overall technical backdrop is balanced. On the one hand, demand for the asset class is being driven by its relatively low duration profile, as well as investors’ general hunt for yield. On the other hand, gross issuance continues to set new records with a busy primary calendar. For example, within European high yield, May marked the fifth consecutive month with greater than EUR 10 billion in issuance (the longest string yet). The deluge of supply should keep spreads in check. Demand has also been lackluster: high yield funds have witnessed net outflows this year of EUR 1.1 billion and EUR 14.3 billion in the US and Europe, respectively. That said, investor indifference and the global dearth of fixed income assets offering positive real yields should remain the overriding technical for high yield. (J.P. Morgan Asset Management, data as of 11 June 2021).
What does this mean for fixed income investors?
High yield is a promising opportunity in an otherwise yield-starved world. The lower duration of the asset class should insulate investors from potential volatility in the rates market while offering attractive carry. From a fundamental standpoint, credit conditions are also ripe for high yield corporates, as firms will increasingly take advantage of economic normalisation and supportive capital markets.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum
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