The recovery in the high yield bond market since the pandemic-induced lows of March has been nothing short of astounding. However, for advisors and their clients there are still some pockets of value if you are willing to work hard, embrace some complexity, and be patient.
Covid-19 hit the financial markets like a tsunami for which we were woefully unprepared. Through swift and decisive monetary action by the Federal Reserve and fiscal stimulus from the Federal Government, massive liquidity was injected into the system, along with an implicit backstop underneath risk assets.
Well-run blue-chip companies were the first to prudently access the investment grade bond market in order to build liquidity war chests for the uncertainty ahead. New–issue concessions were generous, and long-duration IG bonds were the "easy" trade, generating 15-20% total returns. Investors embraced going further down the risk spectrum, providing liquidity to "higher quality" high yield issuers.
Next were companies suffering greatly from the effects of the pandemic, but which could credibly demonstrate that after this temporary interruption, their business would recover and normalize on the other side (hotels, airlines, cruise lines, etc). For these companies, rescue bonds or liquidity bridges were crucial.
As tangible progress was made on vaccines, investors further embraced the vision on the other side of the chasm, and these rescue bonds appreciated significantly in value.
So where does that leave us now?
Many segments of the high yield market are now trading close to cyclical low spreads and historically low yields. The BB ratings segment is at a point where the risk/reward is quite poor in our opinion. As of today, an astonishing 80% of BBs that are callable are trading above their current call price. So if things go well, your bond gets called-away at or below its current price. If things go poorly, either because interest rates rise or credit spreads widen again, investors are left holding the bag. High Yield ETFs and most mutual funds have significant exposure to this segment of the market, both because of its large weighting in the index (56% at 9/30), and also the perceived creditworthiness of the borrowers.
We believe that better value exists along some of the roads less travelled, but you must embrace the treasure hunt. With the spotlight in recent months on the mad dash for refinancing, there still remain areas overlooked by the capital markets despite their businesses having largely rebounded. Pockets of value exist in more complex, out-of-favor, misunderstood situations. It is here where deep-dive fundamental credit analysis is required and rewarded.
If credit markets remain open to issuance, these borrowers will be able to enhance their liquidity and refinance debt maturities. In addition, increasing mergers and acquisitions activity will lead to some of these companies being acquired by higher quality credits. Certainly there are risks, but in many cases they can be mitigated or hedged to provide compelling yields and total returns.
Some examples of sectors and industries where diligence and conviction offer value include certain commodity, industrial and cyclical companies. A recent report by strategists at Goldman Sachs highlights that every soft and hard commodity, with the exception of wheat, is currently in deficit. This is somewhat counter-intuitive, because the destruction on the demand side is well known. However, the interruption of supply chains, and lack-of-financing induced production constraints, has also significantly reduced available supply. And as demand begins to recover, this should push prices higher.