Could politics and energy concerns derail the high-yield rally?

September 2016

Despite a number of defaults by energy issuers and fears over the forthcoming election, US high-yield continues to offer more compelling opportunities than the European market, argues Kevin Mathews.

 

Undeterred by climbing US default rates and the UK’s surprise vote to leave the European Union in June, high-yield bonds have rallied strongly this year as fears over the economy ebbed and as oil prices began to recover in February.

The asset class has returned 10.74[1] per cent in 2016 after suffering its worst year since the global financial crisis with a –2.991 per cent return in 2015. With government bonds yields remaining compressed, the high-yield market has undoubtedly benefitted from investors’ continuing quest for yield. But in the face of the risks to global growth, oil prices, record levels of company leverage and mounting political pressures in the US and Europe in particular, can the rally last?

Energy issuers drive returns

The energy market continues to dominate sentiment in the asset class, particularly in the US where energy groups account for around four-fifths of high-yield debt.

Over two years since Brent crude prices plunged from around $115[2] a barrel in June 2014, to just shy of $28 in February 2016, much of the movement in high-yield markets is a consequence of energy businesses’ debt. The profitability of companies in the sector has been hit as lower demand has caused a significant decline in oil prices.

With oil prices at levels that fail to cover the cost of producing the ‘black gold’ for many companies, more issuers are going bust. Indeed, 62 of the 102 high-yield debt defaults among Moody’s-rated issuers in the first seven months of 2016 were by commodities companies. Of those, 79 per cent were oil and gas businesses with the remainder metal and mining groups[3]

Furthermore, while Moody’s Liquidity Stress Index moderated in July, issuers remain on fragile ground and vulnerable to heightened debt refinancing risk, especially if economic prospects wane or oil prices slide again.

The situation would have been considerably worse, if not for the 88 per cent bounce in oil prices seen between February and June when Brent hit $52 a barrel. This spurred shale oil producers to hedge future revenues[4], allowing them to protect cash flows from lower oil prices and ease their refinancing requirements.

Nevertheless, we remain cautious on bonds issued by energy companies. Despite the bounce seen in many commodity prices since February, the market seems too optimistic on the prospects for oil prices over the medium term.  

Elsewhere, the outlook for other parts of the high-yield market is not as bleak. Stripping out energy issuers, there is no clear trend in terms of which industries are likely to suffer most defaults. And, the worst of the cycle could be over. After the fears sparked by a stronger than expected slowdown in China early in 2016, a global recession looks unlikely in the short term. While default rates are likely to rise in 2016, primarily due to the spike in defaults by energy businesses, overall rates should not soar. Indeed, after peaking at 5.1 per cent in November, credit rating agency Moody’s expects the default rate to fall to 3.9 per cent by July 2017, below its historical average of 4.2 per cent[5].

While the default-rate for non-energy companies is comforting, it is still prudent to be highly selective on individual issuers. The best opportunities continue to be found among higher-quality ‘B’-rated issuers and less so to the poorer quality ‘CCC’-rated credits, which at this late stage of the cycle would be particularly susceptible to any economic slowdown.  

Promising prospects, despite headwinds

While the larger bias to energy businesses among American high-yield issuers means the country faces higher default risk than elsewhere – the trailing 12-month US speculative-grade default rate finished July at 5.5 per cent compared with 2.6 per cent in Europe[5] – the outlook for US high yield looks more promising than Europe. Riskier assets in the latter are likely to be more volatile, at least until more details emerge on negotiations around the UK exiting from the European Union. While risks exist in the US too, such as the outcome of November’s election and a surprise jump in defaults, on balance the country offers more potential upside from a risk-reward perspective than Europe.

European high-yield already looks expensive, with the sector seeing increased flows as yields on euro-zone investment-grade paper shrivel towards zero, if not beyond. Some institutional investors who previously shunned the asset class are looking to include high-yield in bond mandates as relatively flat yield curves amplify pension scheme deficits and encourage schemes to take more risk in the chase for yield. 

Assessing the true value of the European market has become complicated by the intervention of the European Central Bank (ECB), which started buying euro-zone investment-grade debt in June under the auspices of its corporate sector purchase programme (CSPP), another addition to its ‘quantitative easing’ arsenal. The bank is expected to purchase around €9 billion of credit as part of the €80 billion a month of assets the ECB is committed to until March 2017. The bank’s actions have further distorted bond markets, with around €465[6] billion of continental investment-grade credit, in negative yield territory, according to Bank of America Merrill Lynch, up eleven-fold since January.

The impact is not limited to the investment grade sector. According to Barclays, the average yield on continental European high yield debt of at least one-year to maturity was 3.41 per cent[7] at the end of August, while similar US debt yields 6.07[7] per cent. The same yields were 5.37[8] per cent and 8.74[8]per cent respectively at the start of 2016.

The US high-yield debt cycle is at a more mature stage than elsewhere, with the country’s economic recovery more firmly established. Generally the spread between the asset class and US Treasuries is closely tied to trends in high-yield default rates; tightening when the default rate is falling, and widening when defaults rise (see figure). However, spreads have tightened since the market bottomed in February as oil prices started to bounce, despite the climb in defaults. While the prospects of US rate rises, and higher Treasury yields, have receded this year and encouraged more flows into high-yield bonds, the opportunity for further spread compression looks limited.

Global high-yield debt spreads start to tighten as default risk climbs

 

We expect global high-yield bonds will return between three per cent and four per cent in the next twelve months. While this is lower than in recent years, returns still look decent compared with those likely from better quality bonds and shares.

It is unlikely to be a smooth road ahead, however, given the risk that volatility will return in financial markets over the coming months; perhaps emanating from disappointing economic growth, a shock monetary policy shift or a surprise fall in commodity prices. 

 

 

[1] Source: Barclays Global High Yield xCMBS xEMG 2% Issuer Cap 1-5 Year Maturity Index, 31 July 2016, USD

[2] Source: Macrobond, 6 September 2016

[3] Source: Moody’s Investor Services, 9 August 2016

[4] Source: Reuters, 5 July 2016

[5] Source: Moody’s Investor Services, 9 August 2016

[6] Source: Reuters, 21 July 2016, USD

[7] Source: Barclays Point, Barclays US High Yield 2% Capped Index and Barclays Pan-European High Yield Index yield to worst, 31 August 2016 USD

[8] Source: Barclays Point, Barclays US High Yield 2% Capped Index and Barclays Pan-European High Yield Index yield to worst, 31 December 2015 USD

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 5 September 2016. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. 

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In Summary

  • Global high-yield bonds have soared by 10.74[1]per cent in 2016 as a bounce in oil prices and the hunt for yield supersedes higher US default rates and the UK’s surprise June vote to leave the European Union
  • The best value found among high-yield bonds appears to be among the better quality offerings. We remain cautious on bonds issued by energy companies
  • Global high-yield bonds look likely to return between three per cent and four per cent in the next twelve months, though may struggle in the short term
  • Around three-fifths of the 102 high-yield debt defaults among Moody’s-rated issuers in the first seven months of 2016 were for commodities classed companies. Of those, 79 per cent were oil and gas businesses with the remainder metal and mining groups[2]
  • The surge in high-yield issuer defaults is set to peak at 5.1 per cent in November before falling to 3.9 per cent by July 2017, below its historical average of 4.2 per cent[4], according to credit rating agency Moody’s