March 30, 2020

 

With financial markets grappling with the disruption of commerce due to the coronavirus and a price war in oil markets, high yield corporate bonds have sold off dramatically. Option-adjusted spreads[1] for US high yield are now well above 700 basis points (bps)[2], a stress event threshold only breached four other times in the last two decades. While in each of the prior stress events, spreads have widened further, the total drawdown and the duration have not been consistent.

 

With this in mind, we examine four core considerations for an investor looking at high yield at these elevated spreads: (1) current valuations versus history, (2) the range of return outcomes in prior stress events, (3) the path investors had to experience in reaching those outcomes, and (4) the impact of implementation timeliness on returns. In summary, for nimble investors willing to bear with elevated volatility and near-term pain, high yield has historically been a profitable investment at current spread levels.2

 

Current valuations look attractive

Currently over 1,000 bps, US high yield spreads are in the 96th percentile since 2000 (see figure 1).  While the sell-off has so far hit the energy sector the hardest (see figure 2), the general disruption of economic activity has put pressure on high yield spreads more broadly and overall sources of spread are relatively diverse (see figure 3).

 

What is equally noteworthy to the level of spreads is how quickly valuations have changed. US high yield entered 2020 with a little over 330 bps of spread, only about 30 bps above the tightest levels post-crisis, and spreads were under 350 bps just a month ago. The over 600 bps of spread widening observed over the past month is the sharpest month-over-month spread change in index history. In fact, for the year to March 20, 2020, US high yield is already down by a painful 18%.[3] Given this momentum, it is quite possible that spreads will widen further. The goal of this analysis is not to time the bottom of the market, but rather to look to the past for guidance on how spreads have behaved after breaking the 700 bps mark.

Figure 1 – Range of spreads since January 1, 2000


Source: Bloomberg Barclays Indices. Data to March 20, 2020 (which is the “current” date of high yield spreads).

Figure 2 – Spreads (bps) by sector


Source: Bloomberg Barclays US High Yield Index, as of March 20, 2020.

Figure 3 – Sources of index spread

Source: Bloomberg Barclays US High Yield Index, as of March 20, 2020. “Other” includes transportation, utilities and other industrials.

Prior paths through the fog

Since 2000, US high yield spreads have broken through the 700 bps barrier four other times[4]:
 

  • Dot com bubble in 2000
  • Global financial crisis in 2008
  • European financial crisis in 2011
  • Oil price war in 2016

While each incident has its unique characteristics, it can be instructive to look at how high yield debt performed from the outset of stress. This is in many ways the most conservative way to assess returns, as we assume investment exposure throughout the crisis.

Figure 4 – Chart of cumulative high yield returns after hitting 700 bps of spread

Source: Bloomberg Barclays US High Yield Index. Data to March 20, 2020.

Figure 5 – Table of cumulative high yield returns after hitting 700 bps of spread

Source: Bloomberg Barclays US High Yield Index with calculations by Mercer.
Notes: figure 5 is for informational and illustrative purposes only. Cumulative total return is calculated using the percentage change in the index value, which includes reinvestment, from the start date to the end date. The start date is determined by when the index first pasts the 700 bps OAS threshold used to determine a stress event. The end date is a fixed length of time from the start date as described in the table. Time periods have been selected with the benefit of hindsight based on actual historical data and not based on assumptions. Past performance is no guarantee of future results. It is not possible to invest directly in an index. Index returns are gross of fees, transaction costs, or other expenses and include reinvestment of coupon income. [5]

In all periods shown, cumulative absolute returns were meaningfully positive by the third year, despite the losses associated with defaults and the potential impact of fallen angels.[6] However, what is important to mention is the volatility that comes with investing early in a credit cycle downturn. In all cases, there were more losses yet to come, with the maximum total losses another 4% to 31% away. To reap the reward of the elevated level of spreads, investors will have be prepared to endure meaningful volatility and drawdowns.

Being realistic about implementation

Even if one is convinced that high yield will win out over the long run, the question remains of how timely an investor needs to be. With competing investment priorities, governance processes, and the general fear of the unknown, it can be easy to delay on a given investment. Whilst past performance is no guide to the future, we show in figure 6 how the cumulative returns of the initial three-year time period would have been impacted by a variety of delays to the investment.

Figure 6 – Impact of delayed investment on cumulative three-year returns (relative to no delay)

Source: Bloomberg Barclays US High Yield Index with calculations by Mercer.
Notes: figure 6 is for informational and illustrative purposes only. Cumulative total return is calculated in a similar manner to figure 5, except rather than fixing the start date, the end date is fixed at three years from when the index first passes the 700 bps OAS threshold used to determine a stress event. The start date is modified by the amount specified in the table from the date when the index first passes the 700 bps OAS threshold. Time periods have been selected with the benefit of hindsight based on actual historical data and not based on assumptions. Past performance is no guarantee of future results. It is not possible to invest directly in an index. Index returns are gross-of-fees, transaction costs, or other expenses and include reinvestment of coupon income. [7]

The impact of delaying investment has been mixed, which is not surprising since we start the clock near the beginning of a credit downturn. In the two most recent cases, delaying the investment by more than one quarter had a meaningful impact on results, as the initial snap back in spreads was missed. However, in the global financial crisis, the depths of the crisis were not reached until around a year after spreads reached 700 bps.

A helping hand

While staring into the unknown can be daunting for any investor, the past may provide perspective on future outlook. In the case of US high yield, with spreads well past the 700 bps barrier, a level itself only breached four other times in the last two decades, it is time for investors to evaluate whether we have reached an attractive enough entry point to accept the additional risk.

 

1 Option-adjusted spread (OAS) is the measure of the additional spread or yield a fixed income security provides over the risk-free equivalent, taking into account any embedded options.

2 As of March 20, 2020, the Bloomberg Barclays US High Yield Index had an average OAS of 1,013 bps.

3 Source: Bloomberg Barclays US High Yield Index.

4 Source: Bloomberg Barclays US High Yield Index.

5 Information as presented includes inherent limitations given the scenarios that do not reflect actual portfolios managed.  There are frequently material differences between hypothetical results and the actual results subsequently achieved.  Absolutely no representation is being made that such portfolio’s performance would have been the same as such hypothetical results had the portfolio been in existence during such time.   The performance and time periods shown represent a variety of economic and market conditions, including the unpredictability of such conditions and includes periods of volatile market conditions.  Investing in securities involves risk, including the possible loss of principal as the value of investments fluctuates.

6 Ratings changes often lead to significant changes to the constituents in investment grade and high yield indices as downgraded debt is removed from the index for the former and added to the index for the latter. These securities are known as fallen angels.

7 Information as presented includes inherent limitations given the scenarios that do not reflect actual portfolios managed. There are frequently material differences between hypothetical results and the actual results subsequently achieved. Absolutely no representation is being made that such portfolio’s performance would have been the same as such hypothetical results had the portfolio been in existence during such time. The performance and time periods shown represent a variety of economic and market conditions, including the unpredictability of such conditions and includes periods of volatile market conditions. Investing in securities involves risk, including the possible loss of principal as the value of investments fluctuates.

Nathan Struemph
Nathan Struemph

Asset Class Specialist, Fixed Income Boutique

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