High Yield Used to Be Called Junk for a Reason
Date Published: 24 May 2016
The investment industry devises product names designed to reassure, but are often either semi or fully detached from reality. “Junk Bonds” grabbed the headlines in the 1980s when investment scams and high-flying financiers such as Ivan Boesky and Michael Milken, who were known as “junk-bond kings” hit the news. These days “junk bond” funds are known as “high yield” funds — although they are fundamentally the same. These bonds can be volatile and risky, with a typical US high yield bond falling by 24% in 2008.
According to the bond rating agencies, who specialise in predicting the past rather than the future, high yield bonds tend to be those rated by Standard & Poor’s or Moody’s as lower than BBB- or Baa3 respectively. You would logically presume that a so called “High Yield” fund would not hold these lesser quality bonds. Think again. Here in the UK, one of the main investment sectors is the “Strategic Bond” sector — overall we have calculated by analysing the various funds on Bloomberg, that excluding any bonds not rated by S&P, about 37% of a typical strategic bond fund is invested in junk, sorry high yield bonds.
We have been more cautious, with approximately 19% of the SCM Bond Reserve Portfolio holding bonds rated less than BBB-. Even so, we have decided to substantially reduce our exposure to these bonds by selling our one high yield bond ETF within our portfolios. Why? In short, when the price of something goes up fast whilst the fundamentals are deteriorating fast, it’s normally time to get out (fast).
High Yield Performance – 9%+ YTD returns in US and Europe high yield:
Source: SCM, FE Analytics
US high yield bond yields have fallen from 9.5% yields at their February 2016 peak to 7.5% recently, so better value is available elsewhere; particularly when the lowest quality, CCC rated high yield bonds now represent c. 40% of the entire market. The US high yield oil & gas sector (green line) has closely followed the oil price (pink line) but if the recovery in the oil price from the February lows is now going to peter out, so might the performance of the sector.
As someone who has less than no faith in the ability of Goldman Sachs to predict anything generally, and the oil price in particular, it is interesting to note that around the March 11th, they cut their price forecasts of average Brent crude, then around the 16th May, after it had risen by 26%, they announced they were turning more bullish on oil! Good old Goldman Sachs.
As the chart below illustrates, the recovery in the world’s largest high yield market, the US, has benefited from the sharp rise in oil & gas credits, which itself have closely followed the oil price, the average yield of US energy junk bonds has fallen from 21% in February to 11% recently:
Source: SCM, Bloomberg
US high-yield spreads are estimated by Deutsche Bank to price in default rates of about 3.5% by year-end but as recently as May, the overall US high yield default rate was 4.5%, the first time it has exceeded 4% since July 2010, according to Fitch. The exploration and production (E&P) trailing 12-month U.S. high yield bond default rate is at a record 27% helped by four major E&P companies defaulting in May. This is already close to the 30-35% rate expected by Fitch for the E&P subsector by the end of 2016. In 2015 there was $17.5 billion of defaulted energy-sector debt, so far in 2016, it’s already $26 billion.
Source: Bloomberg Finance LP, Datastream, Moody’s Deutsche Bank