High-Yield In Name Only

·         The decline in the average yield of high-yield bonds to a new record low is cause for caution but not panic.
·         High-yield bonds still stand out in a low-yield world, but recent action suggests a closer look at bank loans is warranted.

High-yield bonds may be “high-yield” in name only now. Robust demand for corporate bonds pushed the average yield on high-yield bonds further into record-low territory, closing at 5.75% last week. A mid-single-digit yield just does not seem that “high,” especially for a bond sector that has regularly offered investors double-digit yields and whose yield has averaged 9.9% over the past 20 years. In fact, the average yield of high-yield bonds is now below the long-term 5.9% average yield of their higher quality investment-grade corporate bond cousins, according to Barclays Index data. And just two years ago, long-term high-quality municipal bonds yielding just over 5% were not difficult to find.

An average yield below 6% on high-yield bonds should raise caution but not alarm. The high-yield bond market is merely following in the footsteps of other bond sectors that breached record-low yield territory in recent months and years. In 2010, the average yield of investment-grade corporate bonds and mortgage-backed securities (MBS) dropped to new record lows, according to Barclays Index data. In 2011, intermediate Treasury yields fell to new record lows, and late that year, high-quality municipal bond yields joined the record club. High-quality bond yields descended further into record territory in 2012, and by September of last year, the average yield of the Barclays High Yield Bond Index reached a new record low as well and, like other bond sectors, continued its journey lower.

The average yield drop to a new record low must be taken in this context of a low-yield world. The extraordinary policies of the Federal Reserve (Fed) have been a driving force: first, by lowering overnight lending rates to near zero, and second, by embarking on unprecedented bond purchases that not only reduced available bond supply but also motivated investors into higher yielding debt.

Amid this backdrop, high-yield bonds still stand out in a low-yield world with average yields that are still six times greater than comparable Treasuries [Figure 1].

Figure 1: Despite Lower Yields, High-Yield Bonds Still Stand Out in a Low-Yield World

High-yield bond valuations have become more expensive but remain far removed from 2007 levels that preceded the financial crisis. The average yield advantage, or spread, of high-yield bonds to Treasuries contracted to 5.1% last Friday [Figure 2] due to Treasury weakness coupled with high-yield bond strength. The average yield spread is below the 5.8% long-term average but certainly not representative of the lofty valuations that preceded the financial crisis when the average yield spread bottomed at 2.6% in June 2007. 

Additionally, the following factors are supportive of high-yield bonds maintaining slightly higher valuations:

·         Low defaults. Moody’s Investor Service reported the 12-month trailing global default rate ended 2012 at 2.6%, as fewer-than-expected companies defaulted during the fourth quarter. On a dollar volume basis, the default rate finished the year at a subdued 1.7%. Moody’s forecast that defaults would likely remain low throughout 2013 and end the year at 3.0%, below the long-term historical average of 4.8%. In our view, current yield spreads compensate investors for the level of expected defaults [Figure 2]. Thanks to record-low interest rates, high-yield bond issuers have refinanced a substantial amount of debt and only a limited amount of bonds mature in 2013—a key factor in keeping defaults low.

·         Good fundamentals. Aside from low defaults, credit quality metrics among high-yield bond issuers remain strong. Average debt burdens increased slightly over last half of 2012, but leverage remains low by historical comparison. Furthermore, cash on hand remains near record-high levels, and interest coverage ratios remain near recent peaks. In sum, although credit quality metrics peaked in the middle of last year, they remain supportive of current valuations and vastly different to pre-crisis levels when leverage was high and fundamentals were rapidly deteriorating. Fourth quarter 2012 earnings reporting season, which is underway, will provide additional clarity on corporate bond fundamentals.

Figure 2: High-Yield Valuations Remain Well-Removed From Pre-Financial Crisis Levels and Still Compensate Investors for Expected Defaults

The Moody's default rate represents the percentage of companies rated below investment-grade (Baa3) by Moody's, which have defaulted over the preceding 12 months. Default is defined as a failure to make an interest payment, repay principal at maturity, or debt exchanges where bondholders are forced to accept a reduced principal amount at maturity and terms of original debt are materially altered.

Nonetheless, lower high-yield bond yields suggest a closer look at bank loans is warranted. Should the upcoming battle in Washington over the debt limit turn ugly and risk a government shutdown, or should economic data show increasing odds of a recession, high-yield bond prices may weaken. Despite the factors supporting current high-yield bond valuations and yields, the lower absolute level of yield provides less protection against price declines in the event of a market downturn.

The recent decline in high-yield bond yields further narrowed a shrinking yield gap between high-yield bonds and bank loans [Figure 3]. The declining yield gap suggests that investors can obtain nearly the yield of high-yield bonds but with less price volatility. Bank loans have historically exhibited much less volatility during market downturns due to their seniority over high-yield bonds in the event of bankruptcy. The reward per unit of risk is increasingly pointing to bank loans, especially for more conservative investors. For more on bank loans please see our 11/27/12 Bond Market Perspectives: Banking on Bank Loans.

Figure 3: The Yield Disparity Between High-Yield Bonds and Bank Loans Continues to Narrow

Conclusion
The drop in the average yield of high-yield bonds below the psychologically important level of 6% must be taken with a grain of salt. The now-lower yield must be taken in the context of a low-yield world supported by the Fed’s accommodative monetary policy. Valuations are high across the bond market, as evidenced by record lows across most sectors—not just high-yield bonds. High-yield bond valuations are moderately expensive by historical norms but are supported but good credit quality metrics and low defaults. Should the debt limit not be resolved or the risk of a recession increase, high-yield bond prices may weaken. For this reason, bank loans become an increasingly attractive alternative as the yield disparity to high-yield bonds narrows and provide investors an alternative until the “high” gets back into “high-yield.”

Valeri has been with LPL Financial since June 1993. As Senior Vice President and Market Strategist, Anthony is a member of the Research department’s tactical asset allocation committee and is responsible for developing and articulating fixed income and general market strategy.