Lazard Insights
The Opportunity in US High Yield Jeffrey J. Clarke, CFA, Senior Vice President, Research Analyst
Summary • We believe that US high yield bonds, specifically the higher-quality elements of the market, are one of the strongest opportunity sets in the current economic environment. • Past patterns of high yield performance have shown that higher quality high yield is resilient in rising rate environments, particularly when growth fears are absent. • Oil and commodity sectors drove most of the underperformance in 2015 for high yield bonds. In addition, when these distressed sectors are excluded, 2016 forecasted default rates appear low. • As credit tightens in the future due to higher rates, we expect to see greater disparity in the US high yield market. We believe this environment will offer ample opportunities for bottom-up security selection. For further details on the US high yield market, please read our latest Investment Research, Finding Value in US High Yield Fixed Income.1
Lazard Insights is an ongoing series designed to share valueadded insights from Lazard’s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author on 17 February 2016. The original recording can be accessed via www.LazardNet.com.
In late 2015, investors’ attention zeroed-in on US high yield markets as sentiment soured in connection with price drops in oil and commodities. However, as we look beyond the news headlines and high yield market performance, we see a different picture for investors. In this paper, we will evaluate the basic risks of seeking yield, the normalization of US interest rates, and the current conditions for the US high yield market. Since 2008, central banks have tried to repair the damage from the global financial crisis by cutting interest rates to historic lows. In response, investors have sought income by reaching for higher yield. In fixed income, the extra yield comes with increased risk. The four basic risks an investor can take for compensation are time value, credit, volatility, and currency (Exhibit 1). Time value is a function of the bond’s duration. Investments with different time horizons will behave differently based on interest rate movements. Credit risk is the willingness and/or ability of a bond issuer to pay their debt obligations. Volatility risk addresses the structure of an instrument, and its effect on the lifespan of a security. Depending on the terms and conditions of the security there can be volatility in its price. Lastly, currency risk is embedded in the extra yield. We believe it is important to keep these risks in mind while discussing fixed income—especially high yield—as it must be stressed that yield equals risk, yield does not equal return.
Interest Rate Normalization As yields remains under pressure in the face of investor demand, the challenge of finding attractive yield that is fairly priced has intensified. In our view, a potential solution is US high yield corporate credit and, in particular, non-distressed US corporate bonds rated BB and B. We believe US high yield bonds represent value in today’s market because, in our view, the US economy will continue to grow and interest rate increases will reflect that strength. The period of ultra-low interest
2
Exhibit 1 What Risks Are You Willing to Take for Yield? Time Value Duration
Credit Risk Issuer Category
• Short: 1–3 years
• Government/Sovereign
• Intermediate: 1–10 years
• Agency/Supranational
• Core: 1–30 Years
• Corporate
• Long Duration: 10+ years
• Structured/Securitized
Rating AAA–A BBB–B CCC
Volatility Terms & Conditions
Currency FX
• Callable
• USD
• Sinking Fund
• EUR
• Floater
• GBP
• Prepayment
• JPY
• Linkers (TIPS)
• EM
This information is for illustrative purposes only.
rates since the global financial crisis has been extraordinary and virtually unprecedented. The last instance interest rates were at current levels for a sustained period of time was during the Great Depression. From 1930 through 1938, the US economy was contracting, deflation had set in, and the unemployment rate was at 19%. In contrast, the US economy is quite healthy today. The US Federal Reserve’s plan to unwind its crisis-driven policy and raise rates is supported by annualized nominal GDP growth of 3.5%, inflation below 2%, and a 5.1% unemployment rate.2 In short, we believe interest rate normalization is appropriate given the strength of current economic conditions. Historically, rising interest rates have been challenging for fixed income because of interest rate risk. As rates rise, the value of most bonds decline. For companies issuing high yield bonds, however, rising rates can be generally beneficial if they reflect a positive business environment. High yield bond returns are more tied to economic growth than interest rates or duration. While the asset class is not entirely immune to interest rate risk, it does have lower sensitivity than other fixed income assets. This is due to the higher coupons of high yield debt. Higher coupons are less sensitive to interest rate movement’s vis-à-vis investment grade securities. Over a twenty-year time horizon when rates rose by more than 25 basis points (bps) over rolling 3-month periods, high yield bonds outperformed most other fixed income assets (Exhibit 2). In addition to performing well over the long term when rates rise, high yield bonds have also performed well in more recent rate rise periods. Since 2013, there have been some episodes of meaningful moves in 10-year US Treasury yields. During the second quarter of 2013 and in September 2014 rates rose and, at the same time, investors were nervous about economic growth. As a result, many asset classes performed poorly. However, during the first half of 2015 when investors were solely concerned about interest rate risk, high yield bonds performed well versus other asset classes, especially REITs and US utilities, which are highly sensitive to interest rate movements.
Exhibit 2 High Yield Bonds Are Less Sensitive to Rising Rates Total Return Impact in a Rising Yield Environment, 1994–2015a US Convertibles US High Yield EMD Hard Currency EMD Local Currency Asian Bonds US Corporates IG US Broad Bond Market US 10-Year Treasury -4
-3
-2
-1
0
1
2
3
4
5 (%)
For the period January 1994 to December 2015 (unless noted) a Average over rolling 3-month periods with more than 25 bps rise in 10-year Treasury All data in USD. Asset classes are represented by the following indices: US 10-Year Treasury = Barclays US Treasury 10-Year Bellwethers Index; US Broad Bond Market = Barclays US Aggregate Bond Index; US Corporates IG = Barclays US Aggregate Corporate Bond Index; Asian Bonds = J.P. Morgan Asia Credit Index (since December 2005); EMD Local Currency = J.P. Morgan GBI-EM Global Diversified (since December 2007); EMD Hard Currency = J.P. Morgan EMBI Global Total Return; US High Yield = Barclays US Corporate High Yield Index; US Convertibles = Barclays US Converts Cash Pay Index (since January 2003). The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. The indices referenced herein are unmanaged and have no fees. It is not possible to invest directly in an index. Source: Bloomberg, J.P. Morgan Asset Management
The Credit Cycle In our opinion, the US high yield market is at an attractive point in the current credit cycle, which appears to be lengthening. Historically, these cycles have lasted about seven years, and rising acquisition, leveraged buyouts, and dividend activity often signaled that the cycle was near its end. For example, in the years leading to the end of the prior cycle in 2008 acquisitions, leveraged buyouts and dividends increased from 17% in 2003 to 49% (as a proportion of use of issuance proceeds) by the end of 2007.3 During this time, many high yield companies increased leverage to unstainable levels, which greatly
3
contributed to the end of the credit cycle in 2008 as defaults rose. However, six years into the current credit cycle, such activity remains below peak levels of prior cycles and defaults are near historic lows. Another key point that is supportive of the current credit cycle is the market’s “maturity wall.” One of the main concerns investors have is upcoming maturities in the market. Today’s maturity schedule looks different than the schedule in 2008, when many investors were concerned about a large amount of looming maturities in 2012, 2013, and 2014. In the wake of the 2008–2009 crisis, companies took advantage of the very low rates, as well as easy access to financing, to reissue debt thereby creating a more favorable debt re-payment schedule. The first year we see a significant hurdle for the high yield market is 2018, with approximately 7% of the current market coming due (Exhibit 3).
Performance Analysis: Quality and Sectors Many investors have preconceived notions that the returns of the US high yield market are very volatile. In reality, high yield returns are stable and have historically generated attractive risk-adjusted returns over the long term. Over the last twenty-five years, the Bank of America Merrill Lynch US High Yield Cash Pay Index has returned an annualized 8.1% with an attractive Sharpe ratio of 0.6. Importantly, there is dispersion among the rating categories, with higher quality credits providing stronger annualized returns with a superior Sharpe ratio (Exhibit 4, top table). When exploring performance even further, higher quality high yield bonds, which are represented by BB and B non-distressed credits, have historically outperformed the broader US high yield market with lower volatility (Exhibit 4, bottom table). In 2015, the broader US high yield market returned -4.6%, while BB-B non-distressed credits returned -0.9%. This outperformance was achieved with less volatility as the higher-rated segment of the market had a standard deviation of 5.5% versus 6.4% for the broader high yield market. This pattern of outperformance with lower volatility is also evident in the three-year and five-year time frames. Throughout 2015, market sentiment turned negative due to concerns about oil and commodity prices. This caused spreads to widen for most high yield securities regardless of underlying fundamentals (as a reminder, the spread is the difference in yield versus government bonds). In reality, much of the turmoil in the market was limited to a few sectors, namely lower quality high yield issuers and companies with exposure to oil and commodities. During the year, CCC-rated bonds returned -15% and the energy sector, returned -23.4%. Exhibit 5 (page 4) clearly shows the bifurcation in the market as the higher quality segment, represented by the BofA ML BB-B US Cash Pay Non-Distressed High Yield Index, declined only by about 1%.
Exhibit 3 High Yield’s “Maturity Wall” Has Been Pushed Out to 2018 US High Yield Maturity Profile Outstanding Issues Due to Mature (%) 18
12
6
0 2016
2017
2018
2019
2020
2021
2022
2023
2024 2025+
As of 31 December 2015 This schedule is based on bond maturities. Source: Bank of America Merrill Lynch
Exhibit 4 High Yield Performance Has Been Relatively Strong US High Yield has stronger returns and comparable risk-adjusted results versus the overall US Bond Market, 1989–2015 Annualized Return (%)
Sharpe Ratio
8.1
0.6
BB
8.4
0.8
B
7.6
0.5
CCC
7.1
0.3
6.6
0.9
BofA Merrill Lynch US High Yield Cash Pay Index
Barclays US Aggregate Bond Index
Higher Quality Has Historically Outperformed with Lower Volatility YTD (2015)
BB-B NonDistressed
US High Yield
Return (%)
-0.9
-4.6
Standard Deviation (%)
5.5
6.4
Sharpe Ratio
-0.2
-0.8
Return (%)
2.9
1.6
Standard Deviation (%)
4.8
5.3
Sharpe Ratio
0.6
0.3
Return (%)
5.7
4.8
Standard Deviation (%)
5.4
6.2
Sharpe Ratio
1.0
0.7
3-Year (Annualized)
5-Year (Annualized)
For the period January 1989 to December 2015 (bottom table for periods ended December 2015) US High Yield = BofA Merrill Lynch US High Yield Cash Pay Index; BB-B NonDistressed = BofA Merrill Lynch BB-B US Cash Pay Non-Distressed High Yield Index. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. The indices referenced herein are unmanaged and have no fees. It is not possible to invest directly in an index. Source: Bank of America Merrill Lynch, Barclays Capital, Bloomberg, Lazard
4
Exhibit 5 Higher Quality High Yield Bonds Outperformed in 2015 2015 Return (%)
Index/Rating
Exhibit 6 Defaults Remain Low despite Recent Spread Widening Spreads and Defaults Have Historically Had Strong Correlations Option-Adjusted Spreads (bps)
(%)
US High Yield Master Index
-4.6
1,100
BofA ML BB-B US Cash Pay Non-Distressed High Yield Index
-0.9
900
13
700
10
500
7
300
4
BB
-1.0
B
-5.1
CCC and Lower
-15.0
Distressed
-38.0
100 Sector
2015 Return (%)
Weight (%)a
Energy
-23.4
11.1
Metals & Mining
-25.5
2.9
Paper
-11.4
0.6
Steel
-19.9
1.5
As of 31 December 2015
1998
16
1 2000
2002
2004
2006
2008
2010
2012
2014
2016
BofA ML BB-B US Cash Pay Non-Distressed High Yield [LHS] Moody’s US Speculative Grade Default Rate [RHS] US Baseline Default Forecast [RHS] Fitch
J.P. Morgan
2016 Default Rate Forecast (%)
4.5
4.4
2016 Default Rate Forecast Ex-Commodities (%)
1.5
1.5
11.0
10.0
2016 Default Rate Forecast Energy Sector (%)
a Weight data are based on the US High Yield Master Index The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. The indices referenced herein are unmanaged and have no fees. It is not possible to invest directly in an index. Source: Bank of America Merrill Lynch, Bloomberg
As of 31 December 2015 The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. Estimated or forecasted data are not a promise or guarantee of future results and are subject to change. Source: Bank of America Merrill Lynch, Bloomberg, Fitch, J.P. Morgan
How to Engage the Market Today, many investors may be unsure about how to invest in the high yield market. We believe the bifurcation represents an opportunity in the market. BB-B non-distressed spreads and default rates have historically had a strong correlation (Exhibit 6, top chart). Today, we believe spreads are approximately 200 bps wider than historical averages. For the spread and default relationship to revert to its prior pattern, either spreads need to compress or defaults need to rise. We believe that spreads will narrow. While at first glance the US baseline default forecast is expected to rise in 2016, the key contributor to the rise is the expected default rate in energy for 2016. Fitch and J.P. Morgan are forecasting an 11% and 10% default rate, respectively, in the energy sector. When energy, as well as other commodities, are excluded, the forecasted default rate is only 1.5% (Exhibit 6, bottom table), thereby supporting the idea of spreads narrowing rather than a broad-based rise in defaults to close the gap in the historical spread-default relationship. In order to avoid defaults, security selection is always critical. Even when securities do not default, real impairment exists in the market, which was evident in 2015. For example, Exhibit 7 (page 5) lists ten securities in various industries, all of which sustained dramatic price decreases for the year. The two securities that experienced the largest declines were Chesapeake Energy, an exploration & production company, and Peabody Coal, a metals/mining company. Chesapeake Energy had a 76 point decrease in price while Peabody lost over 70 points in value. As mentioned before, we believe there is an opportu-
nity in the higher quality segment of high yield. This does not mean that we are selecting securities based on ratings alone. In many cases, ratings actually lag market conditions. For instance, in January 2015, S&P rated US Steel BB-. After a tumultuous year in steel pricing, S&P still rated the company BB- at year end, even though the bonds were being traded at distressed levels. This disconnect reinforces the concept that security selection, based on corporate fundamentals, will drive returns in 2016.
Conclusion We believe it is important for investors to understand many of the general risks of reaching for higher yield within fixed income. Yield equals risk, yield does not equal return. With this in mind, US high yield deserves a more detailed analysis for fixed income investors. US high yield has performed well during rising interest rate environments when based on economic growth; and given the current economic outlook for the United States, as well as the current condition of the credit cycle, there is support for the asset class. The higher quality segment of the market, represented by BB-B non-distressed bonds, has produced stable and attractive risk-adjusted returns and, based on current spreads, we believe there is an opportunity for investors. Oil and commodity sectors drove most of the underperformance in 2015 and when these distressed sectors are excluded, 2016 forecasted default rates appear low. In the current environment, security selection will continue to be paramount in the years ahead.
5
Exhibit 7 Impairment Exists in the Market, as such, Security Selection Is Critical Rating Company
Industry
Price
January 2015
December 2015
January 2015
December 2015
Price change 2015
Chesapeake Energy
Exploration & Production
BB-
CCC+
105.5
28.9
-76.6
Peabody Coal
Metals/Mining
BB-
B-
85.0
14.3
-70.7
Linn Energy
Exploration & Production
B
B-
84.0
18.0
-66.0
Penn Virginia
Exploration & Production
B-
CC
82.0
16.1
-65.9
Vanguard Natural Resources
Exploration & Production
B
CC
88.4
30.1
-58.3
Denbury Resources
Exploration & Production
BB
B
91.0
33.2
-57.8
Breitburn Energy
Exploration & Production
B-
CCC+
79.4
22.0
-57.4
US Steel
Steel
BB-
BB-
105.2
51.7
-53.5
AK Steel
Steel
B-
CCC+
92.0
39.1
-52.9
CHC Helicopter
Oil Field Equipment
B+
B
98.6
45.8
-52.8
As of 31 December 2015 The performance quoted represents past performance. Past performance does not guarantee future results. Not intended to represent any product or strategy managed by Lazard. Mention of these securities should not be considered a recommendation or solicitation to purchase or sell the securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. Source: Bank of America Merrill Lynch, Bloomberg
This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm.
Notes 1 Paper available at: www.lazardnet.com/investment-research 2 As of 31 December 2015. Source: Bloomberg, US Federal Reserve 3 As of 31 December 2015. Source: Bank of America Merrill Lynch, Bloomberg, Moody’s
Important Information Published on 17 February 2016. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of 11 February 2016 and are subject to change. The securities and/or information referenced should not be considered a recommendation or solicitation to purchase or sell these securities. It should not be assumed that any of the referenced securities were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond’s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. High yield securities (also referred to as “junk bonds”) inherently have a higher degree of market risk, default risk, and credit risk. This document reflects the views of Lazard Asset Management LLC or its affiliates (“Lazard”) and sources believed to be reliable as of the publication date. There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past performance does not guarantee future results. This document is for informational purposes only and does not constitute an investment agreement or investment advice. References to specific strategies or securities are provided solely in the context of this document and are not to be considered recommendations by Lazard. Investments in securities and derivatives involve risk, will fluctuate in price, and may result in losses. Certain securities and derivatives in Lazard’s investment strategies, and alternative strategies in particular, can include high degrees of risk and volatility, when compared to other securities or strategies. Similarly, certain securities in Lazard’s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Australia: FOR WHOLESALE INVESTORS ONLY. Issued by Lazard Asset Management Pacific Co., ABN 13 064 523 619, AFS License 238432, Level 39 Gateway, 1 Macquarie Place, Sydney NSW 2000. Dubai: Issued and approved by Lazard Gulf Limited, Gate Village 1, Level 2, Dubai International Financial Centre, PO Box 506644, Dubai, United Arab Emirates. Registered in Dubai International Financial Centre 0467. Authorised and regulated by the Dubai Financial Services Authority to deal with Professional Clients only. Germany: Issued by Lazard Asset Management (Deutschland) GmbH, Neue Mainzer Strasse 75, D-60311 Frankfurt am Main. Hong Kong: Issued by Lazard Asset Management (Hong Kong) Limited (AQZ743), Unit 29, Level 8, Two Exchange Square, 8 Connaught Place, Central, Hong Kong. Lazard Asset Management (Hong Kong) Limited is a corporation licensed by the Hong Kong Securities and Futures Commission to conduct Type 1 (dealing in securities) and Type 4 (advising on securities) regulated activities. This document is only for “professional investors” as defined under the Hong Kong Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) and its subsidiary legislation and may not be distributed or otherwise made available to any other person. Japan: Issued by Lazard Japan Asset Management K.K., ATT Annex 7th Floor, 2-11-7 Akasaka, Minato-ku, Tokyo 107-0052. People’s Republic of China: Issued by Lazard Asset Management. Lazard Asset Management does not carry out business in the P.R.C. and is not a licensed investment adviser with the China Securities Regulatory Commission or the China Banking Regulatory Commission. This document is for reference only and for intended recipients only. The information in this document does not constitute any specific investment advice on China capital markets or an offer of securities or investment, tax, legal, or other advice or recommendation or, an offer to sell or an invitation to apply for any product or service of Lazard Asset Management. Singapore: Issued by Lazard Asset Management (Singapore) Pte. Ltd., 1 Raffles Place, #15-02 One Raffles Place Tower 1, Singapore 048616. Company Registration Number 201135005W. This document is for “institutional investors” or “accredited investors” as defined under the Securities and Futures Act, Chapter 289 of Singapore and may not be distributed to any other person. South Korea: Issued by Lazard Korea Asset Management Co. Ltd., 10F Seoul Finance Center, 136 Sejong-daero, Jung-gu, Seoul, 100-768. United Kingdom: FOR PROFESSIONAL INVESTORS ONLY. Issued by Lazard Asset Management Ltd., 50 Stratton Street, London W1J 8LL. Registered in England Number 525667. Authorised and regulated by the Financial Conduct Authority (FCA). United States: Issued by Lazard Asset Management LLC, 30 Rockefeller Plaza, New York, NY 10112.
RD00199