Priced for a Fundamental Recovery
We are constructive on high yield but keeping an eye out for signs of an over-extended rally.
High-yield bond spreads tightened meaningfully in the second half of 2016 on the back of an improving corporate earnings outlook and declining high-yield default rate projections. High-yield bond spreads ended 2016 at only 472 basis points, on average, which is historically consistent with a default rate projection between 2 and 4 percent. Overall, the market appears to be priced for the fundamental recovery that we expect to see in earnings data, interest coverage, and leverage multiples by year-end 2017.
High-Yield Spreads Declined Along with Default Rate Expectations
Declining default rate projections have caused spreads to retrace nearly all of the widening that has taken place since the beginning of the oil bear market in July 2014.
Source: Moody’s, Credit Suisse, Bloomberg, Guggenheim Investments. Data as of 12.31.2016.
The Credit Suisse High Yield index gained 2.5 percent in the fourth quarter, making it the fourth consecutive quarter of positive returns. For all of 2016, the index returned 18.4 percent, its best performance since 2009. High-yield bond spreads tightened 95 basis points quarter over quarter (281 basis points year over year) to 472 basis points, retracing 80 percent of the spread widening that has occurred since the oil bear market began in July 2014. All rating categories delivered positive returns and CCC-rated bonds continued to outperform BB-rated bonds and B-rated bonds.
We remain constructive on high yield at current valuations, but are keeping an eye on early indications that this rally is overextended. For example, the CBOE VIX index, which tends to be closely correlated to changes in corporate bond spreads, has been below its historical average for 52 consecutive trading days. Therefore, potential factors that could spook equity investors may also drive spread volatility in the high-yield sector. Given that the market is already priced for a fundamental recovery, it may be vulnerable to disappointing economic data as well. That said, high-yield spreads have room to tighten from current levels. On average, the troughs in average high-yield corporate bond spreads were 312 basis points in 1998 and 274 basis points in 2007. High-yield spreads also have some room to tighten against investment-grade corporate bonds. While we are not expecting it, in the near term the emergence of disappointing data would cause some contained spread widening. But between now until year end, we expect spreads will see tighter levels.
High-Yield Spreads Over Investment Grade Have Scope to Narrow
Our internal calculations show that high-yield corporate bond spreads have only been tighter 29 percent of the time since 1986 (based on monthly spreads). Although they appear to be rich on a standalone basis, we expect that spreads will see tighter levels this year. When expressed as a premium to investment-grade corporate bonds, the chart shows that between 2005 and 2007, high-yield bond spreads were 61 basis points tighter than today, on average.
Source: Bank of America Merrill Lynch, Guggenheim Investments. Data as of 12.31.2016
—Thomas Hauser, Managing Director; Rich de Wet, Vice President
Important Notices and Disclosures
This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.
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