The arguments against the high yield asset class vary, but we address three of the most common below, providing our own views of these factors and their likely impact on potential returns:
Argument # 1: Credit fundamentals are deteriorating
While it’s true that aggregate high yield credit statistics suffered as commodity prices plunged, our analysis shows that the damage was largely confined to these specific sectors. In fact, excluding the commodity sectors, leverage ratios have been largely flat over the last couple years. And although interest coverage ratios have declined modestly, they remain above historical averages. Looking ahead, the recovery in commodity prices should drive sharply higher earnings in those sectors in 2017, and an expected uptick in growth should bolster the financials of non-commodity sectors.
The bottom line: The stage is set for aggregate credit metrics to improve over the course of this year.
Argument # 2: Aggressive financing has increased the risk in high yield
We find it difficult to square this statement with facts. CCC-rated issuance has actually declined as a share of total high yield issuance in each of the last three years, while BB-rated issuance has increased over the period. The result has been that average credit quality has trended higher. How debt is being used is also worth pointing out. With a lack of meaningful leveraged buyout activity or aggressive M&A financing, a majority of issuance has been used to refinance existing debt, lowering interest costs and extending maturities, thus improving credit profiles.
The bottom line: We have no doubt that the high yield market will ultimately sow the seeds of the next default cycle, but we see little indication that it has done so to this point.
Argument # 3: Retail is the next Energy
There is no denying that secular challenges in the Retail industry are creating significant upheaval and may well accelerate the decline of many old-line retail names. However, we find it difficult to see a transmission mechanism that would allow this sector’s problems to drag the entire high yield market materially lower. Retailers currently represent less than 3% of the Bloomberg Barclays U.S. Corporate High Yield Index. Comparably, Energy represented more than 15% of the Index during the early stages of the commodity sell off (September 30, 2014).
The bottom line: The Retail industry, despite its challenges, is not big enough to create systemic risk in the broader high yield market.
With credit metrics set to improve, risky behavior contained and credit spreads well wide of their post-crisis tights, high yield bonds seem to offer attractive yields and the potential for additional spread tightening.
Historical Perspective for High Yield Spreads (1/31/94 – 3/31/2017)
Past performance does not guarantee future results.
This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) changes in laws and regulations and (4) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.