High-Yield Corporate Bonds: High Valuations in BB-Rated Corporates
Average credit fundamentals are improving, but we remain cautious of valuations and weaker credits.
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.
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.
Source: Bank of America Merrill Lynch, Guggenheim Investments. Data as of 10.10.2017.
—Thomas Hauser, Senior Managing Director; Rich de Wet, Director
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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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