/perspectives/sector-views/high-yield-high-valuations-in-bb-rated-corporates

High-Yield Corporate Bonds: High Valuations in BB-Rated Corporates

Average credit fundamentals are improving, but we remain cautious of valuations and weaker credits.

November 14, 2017


This High-Yield Corporate Bonds sector report is excerpted from the Fourth Quarter 2017 Fixed-Income Outlook.

High-yield credit metrics improved in the second quarter, the latest available data, with leverage ratios down to 4.5x earnings from 4.7x in the prior quarter, and interest coverage up to 3.5x interest expense from only 3.3x in the prior quarter, according to Bank of America Merrill Lynch research. The par-weighted default rate declined further from last year’s peak of 4.9 percent to 1.3 percent as of Sept. 30. These improvements underpin the market’s risk-on mentality, which could last to year end based on seasonal trends we have observed in the past. The markets are also optimistic about tax reform and reflation, which could cause spreads to tighten further, but investors should set realistic return expectations given that 60 percent of the index is trading to call. High-yield corporate bonds’ call protection, which is better than that of bank loans, explains why prices have traded as high as 105 percent of par within the past five years. However, 60 percent of the market is already trading to call, creating large negative convexity in the market.

A Significant Portion of the High-Yield Market Is Trading to Call

With a large share of high-yield bonds trading to call, we would expect future price appreciation will be capped by potential call activity and investors may not earn the full yield to maturity. As the chart shows, the gap between the quoted yield to maturity and the yield to worst is large in these environments.

A Significant Portion of the High-Yield Market Is Trading to Call

Source: Bank of America Merrill Lynch, Guggenheim Investments. Data as of 9.30.2017. YTM = yield to maturity, YTW = yield to worst.

The Bank of America Merrill Lynch U.S. High-Yield Constrained index returned 2.0 percent in the third quarter, its seventh consecutive quarter of positive returns. Spreads tightened by 24 basis points quarter over quarter, ending September at 368 basis points. Performance was mixed by rating, with BB-rated, B-rated, and CCC-rated bonds returning 2.1 percent, 1.8 percent, and 2.6 percent, respectively. Year to date, the high-yield corporate bond market has delivered 7.0 percent returns through the end of the third quarter, on track to meet the expectations that we laid out at the beginning of the year.

With spreads moving closer to historical tights and yields likely to breach historical lows, we remind investors that our Macroeconomic and Investment Research team expects a recession as early as the end of 2019. Investors should be loss-adjusting spreads and yields using default and recovery rate assumptions that are consistent with a recession occurring within the investor’s holding period. Loss-adjusting yields can dramatically change the relative-value assessment between rating categories. For example, historical average annual credit loss rates in BB-rated corporate bonds are about 0.6 percent. If we reduce the BB-rated corporate bond yield by this credit loss rate, we would get a yield that is roughly equal to that of a BBB-rated corporate bond. Given strong corporate fundamentals, we believe there is currently more value to be derived in B and CCC-rated bonds.

Yields Are Approaching Historical Lows

With spreads moving closer to historical tights and yields likely to breach historical lows, we remind investors that our Macroeconomic and Investment Research team expects a recession as early as the end of 2019.

Yields Are Approaching Historical Lows

Source: Bank of America Merrill Lynch, Guggenheim Investments. Data as of 10.10.2017.

—Thomas Hauser, Senior Managing Director; Rich de Wet, Director

 
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.

Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited, and Guggenheim Partners India Management. ©2017, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.


FEATURED PERSPECTIVES

March 02, 2021

A Drunk Man in the Snow: The Random Walk of Interest Rates

Investors’ reach for yield puts downward pressure on 10-year Treasury rates, likely rendering the current yield unsustainable.

February 25, 2021

A Ripe Environment for Strong Credit Performance

Our positive 2021 economic outlook, combined with better-than-expected company fundamentals, supports strong credit performance and spreads.

November 06, 2020

Opportunities in Credit Amid Challenging Conditions

Credit spreads still have room to tighten, but default risk remains elevated in certain sectors.


VIDEO

Third Quarter Outlook 

Third Quarter 2020 Outlook

Brian Smedley, Head of Macroeconomic and Investment Research, and Portfolio Manager Steve Brown share their outlook for the third quarter 2020.

2020 Macro Themes 

Macro Themes for 2020

Brian Smedley, Head of Macroeconomic and Investment Research, discusses major trends likely to shape markets this year.







Read a prospectus and summary prospectus (if available) carefully before investing. It contains the investment objective, risks charges, expenses and the other information, which should be considered carefully before investing. To obtain a prospectus and summary prospectus (if available) click here or call 800.820.0888.

Investing involves risk, including the possible loss of principal.

Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Europe Limited, GS GAMMA Advisors, LLC, and Guggenheim Partners India Management. Securities offered through Guggenheim Funds Distributors, LLC.

© Guggenheim Investments. All rights reserved.

Research our firm with FINRA Broker Check.

• Not FDIC Insured • No Bank Guarantee • May Lose Value

This website is directed to and intended for use by citizens or residents of the United States of America only. The material provided on this website is not intended as a recommendation or as investment advice of any kind, including in connection with rollovers, transfers, and distributions. Such material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. All content has been provided for informational or educational purposes only and is not intended to be and should not be construed as legal or tax advice and/or a legal opinion. Always consult a financial, tax and/or legal professional regarding your specific situation. Investing involves risk, including the possible loss of principal.