It is no secret that global high yield markets continue trading near their all-time low yields that were reached in May 2013. With average yields at 5.39% for the U.S. and 3.77% for Europe (as measured by BofA Merrill Lynch U.S. High Yield and European Currency High Yield indexes as of 14 March 2014), we are still looking at a “medium yield” more than a “high yield” bond market.
Narrow range of outcomes
When assessing trends and opportunities in the high yield market, it is also instructive to look at the distribution of yields around the average to get a better sense for the range of outcomes. Although high yield bonds span a broad range of sectors, industries and individual credits, their yields today tend to fall within an increasingly narrow range – this implies high yield bonds (of all kinds) are trading at levels more similar to each other than they were in 2013 or in 2012. Figure 1 plots this yield dispersion (i.e., the percentage of the market that trades in a given yield range) for the U.S. high yield market.
Avoiding pitfalls and identifying rising stars
Narrow dispersion is a major factor in high yield investing today: It means portfolio decisions that target outperformance should now be guided by avoiding the losers as much as by picking the winners. In addition, there are few total return opportunities still available to offset any potential widening in yields and subsequent underperformance from deteriorating credits. As a result, bottom-up credit analysis has become even more paramount.
At the same time, strategies for picking the rising stars should not be limited to BB/B rated companies with potential for upgrade to investment grade ratings, but also to CCC rated credits where agency ratings lag the improvement in the underlying credit profile. Figure 2 plots the yield dispersion for just the CCC segment of the U.S. high yield market. While CCCs have seen meaningful outperformance relative to the broader high yield market over the last couple of years, the yields in today’s CCC cohort are much more widely dispersed relative to the BB/B cohort. Careful credit selection and research can help identify improving credit profiles and upgrade candidates that are positioned to outperform their benchmark and provide alpha-generating opportunities. At the same time, given CCCs tend to be the most sensitive among high yield bonds to underlying equity valuations, many of these riskier credits now trade at yields too low for their credit profiles that may not be justifiable in the event of an equity market correction.
Prefer U.S. over Europe for total return opportunities in high yield today
European high yield outperformed U.S. high yield in both 2012 and 2013, returning 28.5% and 10.3%, respectively, versus 15.6% and 7.4% for U.S. high yield (according to BofA Merrill Lynch indexes). But European high yield has also seen a more dramatic shift in recent months as spreads have fallen faster than their U.S. high yield counterparts. As a result, dispersion among European high yield is more constricted, and trades well inside U.S. high yield (Figure 3), further limiting total return potential versus U.S. high yield.
That said, investors may find select opportunities among first-time European issuers that are unfamiliar to the high yield market – meaning investors tend to demand higher yields to own them. As with higher-risk credits in the U.S., careful bottom-up credit research can help identify such opportunities in Europe as well.