Default risk of HY bonds will start to trend up in late 2016 onwards, all the way to 2018. This coincides with a global recession that I'm expecting either in 2016 / 17. There will be a dramatic increase in HY refinancing from 2016 onwards. Yields may spike even higher if the global economy is still chugging along slower. Also, with the Fed expected to hike rates from mid 2015 onwards, the higher geared HY issuers may feel the stress.
I will keep my tenors very short and try exposures to HY bond funds instead of individual bonds. Over 10 years, a good HY bond fund will achieve around 6% returns. The volatility is around half of equities, meaning I expect a drawdown of around 25 - 30% in the next crisis. But the recovery of value back to the peak will be swift, with most investors who bought at the peak and subsequently faced a crisis, able to reclaim the peak within 2 years. This is much better than the equity markets which on average took 6 - 7 years to reclaim the 2007 peak.
Why Are Riskier Bond Yields On The Rise?
Following the rise in riskier bond yields, we look at different segments of the high yield market to identify why this has occurred.
December 24, 2014
Even as global bond yields have fallen in 4Q 14 so far (the US 10-year Government Bond yield declined from 2.49% at the start of the quarter to 2.15% presently, as of 23 December 2014), high yield bonds have not had a good run, with segments like Asia High Yield, US High Yield and EM High Yield all posting losses so far in 4Q 14 (as of 22 December 2014, see Table 1). Consequently, this has hurt the performance of funds invested in high yield bonds, with the FSMI – High Yield Bonds, an index tracking the average performance of high yield bond funds on the platform, posting a mere 1.8% year-to-date return after a -1% decline in 4Q 14 (as of 22 December 2014). In this update, we look at events which have driven the recent underperformance in the US and EM High Yield segments.
As shown in Table 2, the worst-hit segments of the US Energy High Yield market appear to be Coal Operations, Oil & Gas Services & Equipment, as well as Exploration & Production (which makes up more than half the US Energy High Yield universe by market weight). It is worth noting that the average yield-to-maturity levels for these sectors are between 14.3% and 20.6%, representing fairly distressed levels. Stripping out the 20 most distressed Energy sector securities (from a universe of 294 names), average yields for Exploration & Production and Oil & Gas Services & Equipment (sectors which tend to be more vulnerable to oil price declines) are still fairly elevated (see Table 2), suggesting that a significant level of negativity has been priced into the Energy sector.
Viewed in the context of expected default rates, the sector’s 941bps spread against risk-free Treasuries suggests that investors are pricing in a 15.7% probability of default* for higher-yielding Energy companies in the US (based on a 40% recovery rate assumption), which is a fairly aggressive assumption in the context of the range of historical speculative-grade issuer default rates (the previous peak was 13.1% for 2009, according to Moody’s data). Granted, the Energy sector faces strong headwinds at the moment following the tumble in global oil prices, although it appears that bond yields in the sector have already moved higher in conjunction with lower crude oil prices.
*Estimated based on Spread/(1 – Recovery Rate of 40%)
Recently released 3Q 14 GDP figures saw quarterly growth revised higher to a 5% annualised rate, the quickest rate since 2003, with consumer spending growing at a 3.2% annual pace. Lower energy prices should continue to support consumption going forward, which suggests that a more positive US economic outlook for 2015 is on the cards; this will ultimately provide a boost to the business prospects of high yield issuers. A combination of more stable Treasury yields (on a more measured pace of Fed rate hikes) alongside a resurgence in US economic growth provides a fairly positive environment for the US High Yield sector and we think the latest rise in yields in the sector represents a decent buying opportunity for investors willing to undertake higher risk in the fixed income market in exchange for stronger potential returns.
With Russia being a major component of the EM non-investment grade corporate bond universe (see Chart 6), geopolitics and the slump in energy prices have combined to fuel a sharp plunge in the Russian rouble so far in 2014, which has raised concerns over the ability of Russian corporations to service their external (USD-denominated) debt. Not surprisingly, non-investment Russian corporate bonds have lost an average of -27.7% of their value in 2H 14 (as of 22 December 2014), while yields have risen by nearly 13 percentage points on average (see Table 3). In contrast, yields for other major countries in the EM non-investment grade space (like Brazil and Mexico) have not risen by the same magnitude, although there has still been a general broad-based increase in yields across both countries and sectors (see Table 4), suggesting heightened investor risk aversion.
Against this environment of heightened risk aversion, investors are now getting better compensation (in the form of higher yields) for their exposure to riskier bonds. It is also worth highlighting that while the two are generally viewed as major components within their respective sectors, the proportion of US High Yield Energy companies and Russian corporations are still fairly small in the context of a well-diversified US High Yield or Emerging Market debt fund.
Investors who are seeking to capitalise on the latest upward move in yields may wish to consider our recommended US High Yield fund, the Allianz US High Yield AM Dis H2-SGD which offers fairly diversified exposure to US High Yield bonds. In addition to our recommended Emerging Market bond fund, the United Emerging Markets Bond Fund, investors who want exposure to the EM corporate bond space can choose from the Deutsche Invest I Emg Mkt Corp LDMH SGD, LionGlobal Emg Mkt Bond A SGD Hedged, Neuberger Berman EM Corp Debt A SGD-H mdis or the Threadneedle (Lux) EM Co Bd Cl ASH SGD, which are all SGD-hedged share classes of Emerging Market corporate bond strategies.
Table 1 - Year-to-date Performance of Riskier Bonds
| YTD* | First 3Q 14 | 4Q 14* | |
|---|---|---|---|
Asia IG
|
8.8%
|
6.8%
|
1.8%
|
Asia
|
8.1%
|
6.9%
|
1.2%
|
Europe HY
|
5.4%
|
4.8%
|
0.5%
|
EM IG
|
7.7%
|
7.3%
|
0.4%
|
IG Corporates
|
2.5%
|
2.6%
|
-0.2%
|
Global Bonds
|
1.8%
|
2.2%
|
-0.4%
|
EM HC
|
5.6%
|
6.9%
|
-1.1%
|
Asia HY
|
5.4%
|
6.8%
|
-1.3%
|
US High Yield
|
1.2%
|
3.5%
|
-2.3%
|
EM HY
|
0.1%
|
5.6%
|
-5.2%
|
| Source: Bloomberg, *as of 22 Dec 14; returns in USD terms except for Europe HY in EUR | |||
US High Yield
Investors have been fleeing US HY funds
With a -2.3% return in 4Q 14 so far (as of 22 December 2014), the US High Yield sector has not been a popular segment of the fixed income market in recent times, with Investment Company Institute data indicating that a hefty –USD 39.5 billion was withdrawn from high yield bond fund strategies over the past six months (May to October 2014, see Chart 1). Consequently, yields for the sector recently rose to some of the highest levels since 2012 (see Chart 2); the yield on the BofA Merrill Lynch US High Yield Master II was recently at 7.28% (as of 16 December 2014), significantly above the 2014-low of 5.16% registered in June.Chart 1: US HY seeing sizable investor outflows
Chart 2: Yields have spiked
Energy has been the main culprit
The recent sell-off in US High Yield bonds has not been indiscriminate, but has been primarily due to weakness in the Energy sector which has been hurt by a precipitous drop in global oil prices. This is evident from Chart 3, which shows the massive widening of US High Yield Energy bond spreads; other segments of the US High Yield bond market appear to be less affected, although spreads have also generally widened in recent months.Chart 3: Energy spreads driving overall US HY
How much bad news has been priced in?
The Energy sector makes up approximately 15% of the US High Yield bond market, making it one of the largest single-sectors for most US High Yield bond funds (see Chart 4). Given the significant widening of credit spreads in the Energy high yield space, it is perhaps worth digging deeper into the sector to see how much bad news the market has priced in at this juncture.Chart 4: Sector Breakdown (US High Yield Bond Market)
Viewed in the context of expected default rates, the sector’s 941bps spread against risk-free Treasuries suggests that investors are pricing in a 15.7% probability of default* for higher-yielding Energy companies in the US (based on a 40% recovery rate assumption), which is a fairly aggressive assumption in the context of the range of historical speculative-grade issuer default rates (the previous peak was 13.1% for 2009, according to Moody’s data). Granted, the Energy sector faces strong headwinds at the moment following the tumble in global oil prices, although it appears that bond yields in the sector have already moved higher in conjunction with lower crude oil prices.
*Estimated based on Spread/(1 – Recovery Rate of 40%)
Table 2 - US HY Energy Sector Breakdown
| Sub-sector | Weight | Average Sector Decline (since end-June 14) | Average YTM | Average YTM (excluding distressed)* |
|---|---|---|---|---|
Exploration & Production
|
57.3%
|
-21.3%
|
15.8%
|
10.4%
|
Pipeline
|
23.8%
|
-5.7%
|
6.2%
|
6.2%
|
Coal Operations
|
8.5%
|
-31.2%
|
20.6%
|
9.6%
|
Oil & Gas Services & Equipment
|
6.7%
|
-28.3%
|
14.3%
|
13.8%
|
Refining & Marketing
|
3.5%
|
-5.8%
|
6.5%
|
6.5%
|
Integrated Oils
|
0.2%
|
-7.7%
|
7.0%
|
7.0%
|
| Source: Bloomberg; data as of 22 Dec 14, *excludes 20 highest-yielding securities in the Energy HY universe | ||||
Improving US economy positive for US High Yield
At this juncture, both yields and spreads are not far from their highest levels in 2014, with the US High Yield market currently offering a yield of 6.71% (as of 22 December 2014, based on the BofA Merrill Lynch US High Yield Master II), representing a 538bps spread against US Treasuries. As guided in our Key Investment Themes and 2015 Outlook, we expect the Federal Reserve to take a gradual, measured approach to hiking interest rates in 2015, with a fragile global economy and muted inflation (on lower energy prices) likely to weigh against improvements in the US economy.Recently released 3Q 14 GDP figures saw quarterly growth revised higher to a 5% annualised rate, the quickest rate since 2003, with consumer spending growing at a 3.2% annual pace. Lower energy prices should continue to support consumption going forward, which suggests that a more positive US economic outlook for 2015 is on the cards; this will ultimately provide a boost to the business prospects of high yield issuers. A combination of more stable Treasury yields (on a more measured pace of Fed rate hikes) alongside a resurgence in US economic growth provides a fairly positive environment for the US High Yield sector and we think the latest rise in yields in the sector represents a decent buying opportunity for investors willing to undertake higher risk in the fixed income market in exchange for stronger potential returns.
EM High Yield
Russian woes
Faring worse than their US counterparts have been the non-investment grade corporate issuers in the EM space, with a -5.2% quarter-to-date decline (as of 22 December 2014), sending yields in the segment to levels in excess of 10% (as of 22 December 2014) – correspondingly, the yield on BB-rated EM corporate debt was at 7% (see Chart 5).Chart 5: Yields spiking
Chart 6: Country breakdown (EM High Yield)
Table 3 - Selected country breakdown (EM HY Corporates)
| Country | Average Yield Change (Since June 2014) | Country Weight (%) |
|---|---|---|
| UKRAINE |
16.8
|
1.3
|
| VENEZUELA |
13.2
|
4.2
|
| RUSSIAN FEDERATION |
13.0
|
16.9
|
| CYPRUS |
10.3
|
0.6
|
| INDONESIA |
7.0
|
4.9
|
| KAZAKHSTAN |
4.5
|
2.3
|
| COLOMBIA |
3.0
|
3.9
|
| MONGOLIA |
2.7
|
0.2
|
| JAMAICA |
2.6
|
2.9
|
| NIGERIA |
2.3
|
1.3
|
| KOREA, REPUBLIC OF |
1.9
|
0.1
|
| BRAZIL |
1.5
|
17.7
|
| VIET NAM |
1.4
|
0.3
|
| EL SALVADOR |
1.4
|
0.3
|
| SOUTH AFRICA |
1.2
|
4.0
|
| BAHAMAS |
1.0
|
0.1
|
| BERMUDA |
0.9
|
0.3
|
| MEXICO |
0.8
|
9.6
|
| CHILE |
0.8
|
2.3
|
| DOMINICAN REPUBLIC |
0.7
|
0.3
|
| SSource: Bloomberg, iFAST compilations as of 22 December 2014 | ||
Table 4 - Sector breakdown (EM HY Corporates)
| Sector | Sector Weight (%) | Average Yield Change (Since June 2014) |
|---|---|---|
| Health Care |
0.2
|
NA
|
| Energy |
11.6
|
9.3
|
| Consumer Discretionary |
4.1
|
7.0
|
| Industrials |
5.4
|
3.7
|
| Financials |
32.3
|
3.4
|
| Communications |
12.9
|
3.3
|
| Materials |
20.4
|
2.7
|
| Technology |
1.0
|
1.9
|
| Consumer Staples |
8.9
|
1.6
|
| Utilities |
3.2
|
0.7
|
| SSource: Bloomberg, iFAST compilations as of 22 December 2014 | ||
EM spreads have widened against their US counterparts
Following the recent happenings in the High Yield bond market, yields on both EM and US High Yield bonds have spiked, offering investors higher potential returns as compared to mid-2014. As Chart 7 indicates, yield increases have been swifter in the EM corporate space, which has resulted in a widening of the spread between the two - as of 22 December 2014, similarly-rated EM corporate bonds yielded 1.92% more than their US counterparts, near some of the widest points since 2011.Chart 7: EM spread widens
Risks have increased, but higher yields mean investors are getting compensated
With the onset of lower energy prices alongside external funding concerns in selected Emerging Markets, investors have now taken a dimmer view of the outlook for High Yield bonds, evidenced by the rise in spreads and yields for both US and EM High Yield bonds. While the situation in Russia remains fluid, latest happenings suggest that legislation is underway to stabilise the Russian banking system while measures have also been undertaken to stabilise the rouble; these should go some way in preventing a wave of defaults by Russian corporate issuers. In the case of the US, the energy sector will likely remain under pressure, although the positives accruing from lower energy prices should be a boon for the US economy, as well as for a fairly large proportion of the US High Yield market.Against this environment of heightened risk aversion, investors are now getting better compensation (in the form of higher yields) for their exposure to riskier bonds. It is also worth highlighting that while the two are generally viewed as major components within their respective sectors, the proportion of US High Yield Energy companies and Russian corporations are still fairly small in the context of a well-diversified US High Yield or Emerging Market debt fund.
Investors who are seeking to capitalise on the latest upward move in yields may wish to consider our recommended US High Yield fund, the Allianz US High Yield AM Dis H2-SGD which offers fairly diversified exposure to US High Yield bonds. In addition to our recommended Emerging Market bond fund, the United Emerging Markets Bond Fund, investors who want exposure to the EM corporate bond space can choose from the Deutsche Invest I Emg Mkt Corp LDMH SGD, LionGlobal Emg Mkt Bond A SGD Hedged, Neuberger Berman EM Corp Debt A SGD-H mdis or the Threadneedle (Lux) EM Co Bd Cl ASH SGD, which are all SGD-hedged share classes of Emerging Market corporate bond strategies.
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