The demand for US junk bonds has rarely been higher.
Yield for the country's sub-investment grade debt hit an all-time low earlier this month, amid mounting investor demand. The yield of the S&P US High Yield Corporate Bond Index, a benchmark index for the asset class, has been narrowing after spiking during February and early March last year, amid the early stages of the Covid-19 pandemic outbreak. The index descended to a trough on February 11 when its yield-to-worst fell to 3.86% while yield-to-maturity dropped to 4.57%.
"The S&P US High Yield Index hit an all-time low yield in February, only returning above the 4% threshold for the first time in two weeks," Brian Luke, global head of fixed income indices at S&P Dow Jones Indices, told AsianInvestor.
Issuers have been eager to take advantage. The Financial Times reported on Saturday (February 20) that Centene Corporation issued a 10-year high-yield bond at 2.5% earlier this year, nearly on a par with investment-grade corporate bonds and less than the US government would have paid for the same maturity, two years ago.
Walter Kilcullen, head of US high yield at fund manager Western Asset Management, argues such ultra-low junk yields are an outlier. However, he acknowledges that that investor demand for high yield had grown, and led to these sharply narrowing yields, as global economies show signs of economic recovery, and with signs of new supply likely to be lower than that of 2020.
Do current yield levels on junk bonds offer a reasonable rate of return for borrowers that, by their very nature, offer a sizeable risk of default? Or has investor exuberance led to a bubble in US high yield debt?
AsianInvestor asked nine leading investment professionals to share their views on the appeal of high-yield bonds and where opportunities may continue to exist.
The following contributions have been edited for brevity and clarity.
Ian Coulman, chief investment officer
Pool Re (London)
Within our investment grade mandates we have a global approach. Our high yield exposure, which forms part of our multi-asset credit mandate, is dominated by US bonds, as it remains the largest high yield market.
From a value perspective, I agree – and our fund managers tend to agree – that as much as the yield is attractive, US high yield is getting expensive. As is the case with a lot of different bond markets, credit spreads have narrowed to below the long-term average, in some cases even tighter than at the start of 2020.
So we believe it’s important to maintain a cautious approach, but at the same time the money has to be invested somewhere. You’ve got to look at it on a diversified and risk allocation basis.
Walter Kilcullen, head of US high yield
It’s important to note that the issuer offering the 2.5% bond coupon is an outlier and expected to be upgraded to investment-grade very soon. We think the broader high-yield market yield is still about 4%. However, while yields are at all-time lows, we are not at all-time tightness with regards to spreads.
Overall valuations for high-yield are less attractive than in the recent past because the technical backdrop remains very positive, despite the expiration of the Fed’s explicit backstop. What’s more, the rate of new-issue supply is expected to trend lower than 2020’s pace, while demand is expected to remain robust in a world starved for yield.
Market technicals are particularly strong for Asian investors, in large part due to favorable hedging costs. Over the past six years the cost of a yen/dollar currency hedge averaged 1.63%; today the cost is 0.34%, the lowest level for this period. Considering that negative yields are prevalent in a majority of the global fixed-income market, we believe high-yield currently offers an attractive yield and the potential for capital appreciation as economies reopen.
Patrick Tsang, chairman
I believe that the market may have mispriced the credit quality of certain high yield issuers, for instance, their default risk. In particular, the US middle market segment receives relatively less scrutiny from credit rating agencies, underwriters and asset managers.
In addition, high yield bonds have demonstrated a more attractive risk and return profile over the last 30 years in comparison with S&P 500. With the quantitative easing of various central banks leading to all-time low-interest rates, this decreases the attractiveness of other bonds, so US high-yield bonds might serve as a good diversifier if the investors have the appropriate risk tolerance and appetite.
If we have to choose bonds as an asset class to invest in, it would be Asian high yield bonds. With the rapid recovery of Chinese and Asian economy, we believe the investment momentum is with Asia. Asia’s default rates are low historically and it has the potential to generate resilient income and attractive risk-adjusted returns. China is the world’s second-largest bond market. In the future, investors need to accept that China is going to comprise a bigger part of any fixed income or credit portfolio.
Cheung Chilok, portfolio manager, delegated solutions
Growth fixed income, which typically refers to high yield and emerging market debt, will remain relevant in strategic allocations when it comes to constructing resilient investment portfolios. We trust that the wide credit quality spectrum within the high-yield asset class continues to offer plenty of investment opportunities.
High-yield debt performance has been extremely strong over the last three quarters. It is obvious that high-yield valuations have become less attractive, as spreads have continued to narrow and are now just moderately wide of where they entered 2020. Similar to the global credit markets, risk sentiment in the US high-yield market continues to improve.
Despite this significant yield compression, we remain constructive regarding the future prospects of the asset class as the vaccines, on-going Fed support, and improving credit quality should serve as a tailwind over the medium term. Importantly, forward-looking default rate expectations have continued to trend lower, and we believe investors are seeing sufficient reward for the level of risk amid the current backdrop.
Rohan Duggal, investment specialist for high yield debt
JP Morgan Asset Management
Fourth-quarter 2020 US earnings have demonstrated that the US recovery is well under way. Just as Americans receive their vaccinations, the economy is soon to get its own booster via the Biden administration’s stimulus package.
Unprecedented fiscal and monetary support have kept capital markets firmly open to borrowers, resulting in current defaults already below 2020 levels. Rising stars are also eclipsing fallen angels due to upgrades. Finally, the sharp rebound in oil prices spells relief for the beleaguered high yield energy sector.
Current spreads need to be seen in the context of where we stand in the credit cycle. Markets are correctly anticipating fundamentals to improve. While valuations are not cheap, history has shown that periods of low spreads can last for years.
In this carry environment, security selection will be pivotal. Though interest rate moves may undermine credit returns, in a carry environment US high yield should be better insulated from rate moves than lower-yielding fixed income assets with longer duration.
Andrew Zurawski, associate director for Asia investments
Willis Towers Watson
Given the current macroeconomic environment of heightened uncertainty, we retain a cautious outlook for US high yield credit as we consider the risk of significant near-term volatility and further near-term spread widening to be material.
To put this into context, the yield to maturity of the Markit iBoxx High Yield Index is currently less than the 4%. This is below the yield on offer in the Chinese government bond market, which is an area of the market we see some value for investors.
One of the portfolio priorities we suggest for investors this year would be to revisit unlisted asset exposure with credit like qualities. Some unlisted assets currently offer relatively elevated risk premia to bonds, and this risk premia are one of the last to be impacted by policy stimulus. In a world of low bond yields, the income offered by many unlisted assets is very valuable.
George Efstathopoulos, portfolio manager
In the US high yield market, bonds with the lowest credit rating have significantly outperformed better rated bonds. The rally also pushed the yield on triple-C rated bonds below their average coupon for the first time since 2015, strengthening the refinancing impulse for issuers.
While this type of activity can be a sign of market froth and increasing risk, I think it’s important to note that this time there are mitigating circumstances.
Firstly, issuance proceeds have been mostly limited to refinancing or productive capex, while dividend recap issuance, which is less favourable to bondholders, is at post-great financial crisis lows. Secondly, the quality of the US high yield market has never been better in terms of rating. The share of triple-C rated bonds is at the bottom end of its historical range. Finally, the macroeconomic backdrop remains supportive and the Federal Reserve’s monetary policy remains highly accommodative.
Nevertheless, it’s not the right time to chase the beta rally. I believe it’s better to take an active approach. In the context of a global upswing, the expected coupon-like return of high yield bonds from here remains attractive and its short-duration nature may make it more resilient than longer-duration assets like investment-grade bonds and even some large-cap equities.
Ariel Bezalel, head of strategy for fixed income
Jupiter Asset Management
Central banks realise that the credit markets are a key source of finance for corporates as the global economy enters the recovery phase from the global pandemic. On this basis, we have been of the view that the asset class will be well supported by central bank policies.
Of late, however, we have turned a bit more cautious on credit markets as spreads are pretty much back to the tights. The absolute yield on US high yield has now reached record lows at sub-4%. In turn, we have reduced our spread duration with a preference for high coupon, short dated paper typically issued by companies in more defensive sectors.
For risk assets more broadly, we could be entering a more challenging period with government bond yields on the rise. In such a highly indebted world combined with an uncertain economic outlook, higher rates present an awkward problem for high yield bonds at such tight spreads. Longer term, we do believe rates will likely stay lower for longer, driven by ongoing heavy global indebtedness and ageing demographics in much of the developed world.
Cosmo Zhang, research analyst
Vontobel Asset Management
Although the spread differential between Asia and US high yield has declined in recent months it is still over 350bp, at the wide end from a five-year or even one-year perspective.
The attractiveness of valuations in US high yields to Asian investors is very limited, given that the overall US high yield index is trading only at half the spread level that investors can get in Asia high yield. This is interesting, given that Asia high yield index is almost two times shorter in duration than those of US high yield (3.3 years for Asia and 6.5 years for US), and Asia high yield 'BB' is also almost two years shorter than equivalent US high yield 'BB'.
We believe that we are more likely to see global inflow into Asian high yield instead of Asian flow into US high yield. Asian investors looking for geographical diversification should explore the wider emerging markets or developed markets. We noticed fund flows for US high yield have been relatively stable, despite some small changes this year.
Joe Marsh contributed to this article.