High yield markets saw tremendous volatility this summer. How does this affect the sector’s outlook? PIMCO high yield portfolio managers Andrew Jessop and Hozef Arif discuss recent developments in the market, the underlying drivers and key risks and opportunities going forward.
Q: What caused the recent selloff in the high yield market, and what are the key market trends today?
Jessop: The high yield market has been on a roller coaster ride throughout the third quarter, trading up and down through a range spanning 105 basis points (bps) of spread and 150 bps of yield, just since late June, when yields reached all-time lows. While valuations contributed to this activity, especially at the onset, technical factors such as unpredictable flows – including volatile ETF activity – and imbalanced supply and demand have dominated high yield performance so far in the second half of 2014. (High yield market data is proxied by the Bank of America Merrill Lynch US High Yield Index, spreads are the weighted-average option-adjusted spread (OAS) or yield versus like-duration Treasuries, and yields are represented by the yield-to-worst (YTW) as calculated by the index provider.)
Following the benign high yield market environment of the first half of 2014 – characterized by strong fundamentals, supportive technicals, compressing spreads and plunging yields – the second half of the year has turned a radical about-face on most of these fronts. Technicals, in particular, saw retail U.S. mutual fund inflows totaling $5 billion year to date through June (with 20 out of 26 weeks of inflows), only to have them quickly erased with massive outflows of $11.4 billion in the month of July alone – please see Figure 1.
Of note is how the typical conditions that accompany a bout of retail U.S. mutual fund outflows, such as a weak equity market, rising Treasury yields, elevated levels of financial stress and heightened levels of volatility (as measured by the Chicago Board Options Exchange Volatility Index, or VIX) were not in place through most of July. Instead, a barrage of negative news articles on stretched valuations in leveraged finance, elevated geopolitical risk and a swelling of sovereign credit concerns drove these outflows, which became part of a feedback loop leading to poor performance and then more outflows. However, during August, amid lack of new supply, yields fell back to 5.30%.
Since Labor Day, however, a relatively large primary market calendar, amid retail outflows and overall equity volatility, has pushed spreads and yields well wide of their beginning-of-the-year levels: 450 bps and 6.46%, respectively, in late September. We have not seen these levels since this time last year.
Q: Have fundamentals weakened in the high yield universe?
Arif: Actually, fundamentals have improved slightly at the margin, and we believe this has been a catalyst for institutional investors to consider utilizing the recent selloffs and higher yields as an opportunistic entry point to add exposure to high yield. Earnings have been growing at a strong pace of 8.7% through the second quarter, according to all publicly reporting high yield issuers. Nearly all industry categories registered positive year-over-year growth in EBITDA (earnings before interest, taxes, depreciation and amortization), leverage declined and margins held up at a healthy 27.6%. Notwithstanding the recent volatility in equity markets, high yield companies continue to benefit from elevated equity cushions as enterprise valuation multiples have expanded. And while M&A activity has seen a pickup in 2014, leveraged buyouts as a percentage of total M&A volume are only 6%, well below the peak of 18% we saw in 2006.
Albeit more of a backward-looking indicator of fundamentals, the default rate at 2.2% is less than half its historical average; please see Figure 2. Given the substantial decrease in interest costs attributed to low refinancing rates and the subsequent all-time high interest coverage ratios, not to mention the relatively small amount of bonds maturing over the next two to three years, we do not expect defaults to pick up in any meaningful way over the foreseeable future. That being said, there are pockets of stress in the market, most notably in sectors facing secular demand challenges, such as retail and mining.
Q: What is PIMCO’s assessment of the quality of recent new issuance?
Jessop: September’s $44 billion of new issuance is the highest monthly total since September 2013 and has come amid a backdrop of significant U.S. mutual fund outflows totaling $3.5 billion for the month. Larger, more liquid and higher-quality deals dominated the primary market: BB rated issuance was greater than 60% of the share of September’s total new issue volume compared with a 45% share of the outstanding high yield market. BB rated deals also distinguished themselves by outperforming all the other deals by 40 basis points on average. Higher-quality deals also benefited materially from opportunistic buyers, such as high quality income funds, investment grade portfolios and crossover investors. As another reflection of the increasing quality of issuance, several deals were pulled or postponed during the month as a result of investor pushback.
Q: Are valuations fair for high yield as an asset class, given PIMCO’s secular views? Jessop: With the exception of two days in May 2013, when they touched 4.99%, speculative grade yields had never dipped below 5% prior to this year. Then, in June, yields spent the majority of their time below 5%, reaching an all-time low of 4.85%. These levels are relatively uncharted territory and there was certainly a case to be made that valuations were stretched, even alongside strong fundamentals. The “carry” trade was essentially the only case in play.
Today, however, given the technically sourced pressure on the high yield market, spreads and yields are materially wider, as I mentioned earlier, and fundamentals remain just as compelling. Furthermore, the average price has fallen nearly 4.5 points and is approaching par. Despite negative performance during the third quarter, total year-to-date returns for the high yield market are still positive, in line with the coupon-clipping pace we predicted to begin the year.
Going forward, we expect high yield performance will continue to be dominated by coupon income. However, with average prices just above $101, a buyer in the high yield market has potential for capital appreciation as well, if – as PIMCO believes – Treasuries are likely to remain range-bound and defaults do not pick up materially. The recent market turmoil has improved the relative value of high yield bonds and we believe provides an attractive entry point, especially given the corresponding rally in “risk-free” rates and the continued strong fundamentals of most of the underlying credits in the asset class. And given PIMCO’s view for a lower-growth global economy and subdued interest rates over the foreseeable future – an outlook we call The New Neutral – the case for high yield bonds is a compelling one, both as a tactical and strategic allocation.
Q: How should investors position themselves within the high yield market with respect to relative value, and to the U.S. versus Europe?
Arif: The limited dispersion of speculative grade bond yields and performance across sectors continue to be relevant themes, despite the recent volatility. We see strong opportunities in the primary market, with higher-quality bonds at more attractive terms relative to those issued earlier in the year alongside the strong rally. From an industry perspective, we favor industrials, healthcare, cable/wireless and energy, specifically companies that have high quality underlying assets and high barriers to entry. Conversely, we remain guarded in the retail and mining sectors, which have generally lower-quality assets and longer-term demand challenges.
Regionally speaking, we see the best opportunities in the U.S., where we think growth prospects are better than in Europe. Furthermore, following the strong run that Europe had throughout 2013 and the early months of 2014, European high yield spreads are now trading 50 bps tighter than similar spreads in the U.S. And with yields in the U.S. almost 200 bps north of those in Europe – please see Figure 3 – U.S. high yields bonds are better positioned to absorb a potential increase in rates should that play out gradually even as Europe embarks on a path of prolonged stimulus, given the weaker economy. One area in Europe where we do see attractive relative value is in subordinated bank capital securities that benefit from monetary policies of the European Central Bank. Investors could look to add exposure here via select new issuance.
Whether in the U.S. or Europe, credit research and security selection remain paramount. At PIMCO, while broad market themes act as the guardrails to our analysis, we construct our portfolios based on where we see the best value on an individual credit-by-credit basis.