The high yield market typically has a lower duration than other fixed income markets due to a combination of higher coupons and shorter maturities. This helps to insulate it from movements in interest rates – a characteristic that is becoming increasingly valuable as the market anticipates a rise in US interest rates. The chart below shows how US high yield has historically provided better excess returns in periods where 10-year Treasury yields increase by more than 100 basis points (bps).
High yield tends to exhibit a higher level of idiosyncratic risk than other areas of fixed income, with individual company factors proving a bigger determinant of the bond price than is the case for investment grade bonds. As the correlation table below demonstrates, high yield also has a stronger correlation with equity markets, making it a useful diversifier within a fixed income portfolio.
Default rates expected to remain low
For a long-term investor, the heightened risk of default is the key driver of spread premia for high yield bonds. We expect default rates to remain low for an extended period given sensible leverage, lack of capex and historically-low interest rates – the exception to this being the energy sector which is troubled by over-investment meeting a collapse in oil prices.
In a recent study, Deutsche Bank remarked that 2010-2014 is the lowest five-year period for high yield defaults in modern history (quality adjusted). To protect for default risk in BB and B-rated bonds over this period, investors would have required spreads of 27bp and 94bp respectively. To put this in context, current European/US BB spreads are 314/346 bp and B spreads are 528/518 bp2, suggesting high yield bonds in aggregate are more than compensating for a moderate pick up in defaults.
Although we are seeing evidence of late cycle activity in some sectors in the US, at a more broad level and globally companies are still using the proceeds of their high yield bond issues for non-aggressive activities such as refinancing. Bondholder unfriendly activities (issuing bonds to pay for leveraged buyouts or to pay dividends to equity holders) remain well below the worrying levels of 2005-07.
Article by Kevin Loome, who joined Henderson Global Investors in 2013 as the Head of US Credit
