High-Yield Corporate Bonds: The Rally that Lacks Conviction
Not all prices in a strong first half were lifted equally by this Fed-induced rally.
Several themes emerged in the first half of 2019. Chief among them was the desire to extend duration as Treasury yields fell across the curve with the market pricing in Fed easing over the next 18 months. Since peaking above 3 percent in 2018, five-year and 10-year Treasury yields have fallen to near 1.8 percent and 2.0 percent, respectively, as of late July. But not all of the performance was rate-driven in high-yield corporates, since spreads have compressed meaningfully since the beginning of the year. Other features of this rally included a preference for liquidity offered by large capital structures. BB and B bonds in issues of larger than $1 billion delivered excess returns over Treasurys of 6.8 percent and 7.0 percent, respectively, compared to excess returns of 5.5 percent and 5.1 percent for BB and B bonds sized between $250 million and $500 million.
Total return through the first half of 2019 for the ICE BofA Merrill Lynch High-Yield Constrained index was 10.2 percent, with excess return over Treasurys representing 5.9 percent of that. The increased attractiveness of high-yield corporates due to their fixed-rate nature gave the market a meaningful boost in performance over similarly rated floating-rate sectors. For example, BB corporates have outperformed BB loans by 4 percentage points year to date through July 24, and they outperformed BB CLOs by 3 percentage points.
High-Yield Corporates Outperformed Similarly Rated Floating Rate Sectors
BB corporates have outperformed BB loans by 4 percentage points year to date through July 24, and they have outperformed BB CLOs by 3 percentage points.
Source: Guggenheim Investments, ICE BofA Merrill Lynch, JP Morgan, Credit Suisse. Data as of 7.24.2019.
In the first quarter, we noted some signs that this rally lacks conviction, which continued through the second quarter. CCCs are lagging in performance, with the category’s excess returns over Treasurys at 4.5 percent year to date, compared to 6.8 percent in BBs and 6.0 percent in single-Bs. Since the beginning of June, when the Fed sent clearer signals about a possible rate cut in July, CCC excess returns have been largely flat while BBs and Bs earned positive returns over Treasurys. We forecast that the 12-month trailing par-weighted default rate will climb to about 3 percent by year end, up from less than 1 percent currently, and will ease in early 2020. But the gap in excess return between higher beta CCCs and lower beta BBs points to brewing market concerns over credit risk. Even as the Fed's stance has become more accommodative, this rally is more driven by liquidity than fundamentals and may leave the riskiest borrowers exposed.
CCC Excess Return Divergence from BB and B Signals Credit Concerns
Since the beginning of June when the Fed sent clearer signals about a possible rate cut in July, CCC excess returns over Treasurys have been largely flat while BBs and Bs earned positive returns over Treasurys.
Source: Guggenheim Investments, ICE BofA Merrill Lynch. Data as of 7.24.2019.
—Thomas Hauser, Senior Managing Director; Rich de Wet, Director
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