While most segments of the bond market have been in trading ranges this summer, the high-yield corporate market has seen a significant sell-off. Yields have increased as much as 100 basis points (bps; 100 bps equals 1.00%) since early June, with average prices down as much as 5 points. Since June 20, the high-yield market has recorded a total return of -1.5%, while the investment-grade corporate market shows a positive return of 0.9%.
That performance has raised fears that this is the onset of the widely predicted reversal of the five-year cyclical rally in high yield. Because yields had reached such low levels, the eventual cyclical rise in yields was often predicted to be brutal. This episode, however, appears to be a limited market correction rather than a prolonged cyclical bear market. It has been primarily a response to external factors rather than deteriorating credit fundamentals.
Geopolitical events that hurt the equity market—events in Ukraine and the Middle East—have similar effects on high yield. A flight to safety among global and domestic investors often sparks rallies in Treasuries and corrections in equities and high yield. Over the past six weeks, domestic equity and high-yield corporate mutual funds and exchange-traded funds have experienced net outflows as investors shifted away from what are regarded as riskier assets. This can likely produce a snowball effect, as selling to meet withdrawals typically lowers prices and net asset values, which, in turn, encourages more withdrawals.
Broader credit market still points to low-interest-rate environment
Another explanation for the high-yield sell-off is that investors are preparing for the cyclical rise in rates. If that were true, however, yields would likely be rising in other segments of the bond market. But yields on Treasuries, municipals, and investment-grade corporates have been stable to lower over the past six weeks. We believe those markets are responding to fundamentals that still suggest a considerable period of low interest rates and bond yields. Moderate economic growth in the U.S. and anemic growth overseas typically are not the type of fundamentals that generate significant cyclical interest-rate pressures.
Those global fundamentals could, in fact, help limit the sell-off in high yield. With 10-year sovereign yields as low as 1.10% in Germany, 1.50% in France, 0.45% in Switzerland, and 0.50% in Japan, the higher yields now available in U.S. high yield might soon attract demand from overseas. In our view, the risk/reward tradeoff versus sovereign debt is now much more favorable to high yield. It is also more favorable versus investment-grade corporates.
None of this would matter if the credit fundamentals were deteriorating. But corporate earnings and cash flow are still healthy, defaults are at or near cycle lows, and the so-called wall of refinancing has been pushed out to 2016–2017.
History and credit fundamentals suggest a short-lived correction
Historically, credit fundamentals are the key to cycles in high yield. During the 2004–2006 period of Federal Reserve tightening and relatively low yields, there were two instances in which yields rose 100 bps or more. Those proved to be short-lived corrections, and the high-yield market recorded an average annualized return of 8.4% over those two years. It was not until mid-2007, when recession signs warned of a weakening in credit fundamentals, that the cyclical rise in yields began.
The current market setback is the third major rise in yields for this cycle. In the third quarter of 2011, yields rose 300 bps but then declined almost as sharply in subsequent months. The high-yield index recorded a total return of -6% in the third quarter and +6% in the fourth quarter of 2011. In 2013, yields rose as much as 150 bps and then declined even more than that in subsequent months. The current backup in yields is, in our view, much more similar to those corrections than to the cyclical bear market of 2007–2008.
Higher yields more adequately compensate for higher risk
It has been argued that at the low yields reached in May to June, investors were not being adequately compensated for the risks of owning junk bonds. With yields sharply higher now,we believe that is no longer a reason to be exiting high yield. The argument that this is only the start of a prolonged cyclical rise in yields is, in our view, inconsistent with the current economic and credit fundamentals. With the cyclical rise in interest rates and bond yields still not in sight, investors should continue to seek income rather than safety, and the high-yield market now offers substantially greater income potential than two months ago.