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Changing Face of High Yield

May 14, 2013

by Christian Thwaites

of Sentinel Investments

High yield has been on a tear. A series of fortunate events have made this one of the best asset classes in recent years. It has outperformed the S&P[1] nine out of the last thirteen years. In those that it lagged, underperformance averaged 1.9%. Outperformance averaged 9.7%. From 1985 to 2012, high yield had five down years averaging (-8.8%). The S&P had five down years averaging (-16.6%). Over the entire period, high yield underperformed the S&P by around 180bp but with about half the risk and a 0.58 correlation. Since 2000, high yield wins hands down with an annualized return of 7.8% compared to the S&P of 1.6%.

Along the way, we saw the widest and lowest spreads, record supply, higher recovery rates and the lowest level of fallen angels. Here's the spread:

Source: Federal Reserve Bank of St. Louis, Economic Research

The spread as of this past Friday was in the low 400s, compared to 468bp in January and over 2,000bp in March 2009. So the market has done well. Why?

First, start with the premise that QE distorts fixed income markets. One of the outcomes of QE and a ZIRP has been disinflation and some removal of duration risk in capital markets. Low inflation and high nominal rates set us up nicely. Second, credit. It’s only recently that the Fed’s Senior Loan Officers Opinion Survey showed any loosening in credit conditions. But lending standards remain high and, more important, demand for C&I loans has barely moved. Much of the demand shifted into credit markets bypassing commercial banks altogether. And, third, supply of credit has shown up with insurance companies, always hungry for yield to match long-term liabilities, and retail. High yield mutual funds are now the third largest fixed income category with assets equivalent to about 30% of the index. Compare that to equity mutual funds, which are about 18% of the S&P.

Breaking Down High Yield Risk

The tail wind of low yields, defaults, spreads and better recovery means shifting sources of return in high yield. In a more mannered environment, spreads comprise:

(1-Recovery Rate) x (Default) + (Excess Spread) + (Liquidity Premium)

So the bonds trade mostly on default, recovery and liquidity. And that made them more equity than fixed income-like. What’s missing, and what is far more important in sovereigns and IGs, is duration risk. That’s changing. The traditional drivers in high yield are less important in a market where companies have plenty of access to credit, better balance sheets and therefore lower default risk. So we’re left with duration risk. The Treasury 10-Year note trades with a 9.1 duration. If rates rise 200bp in the next two years, the loss will be around 7.2%. If we’re right and high yield trades with more duration, then the traditional diversification benefits diminish.

We still like the market but it means we’ll hedge out duration risk using treasuries and the capital structure risk using equity derivatives. That’s not anything we’ve had to do much in the past. But we're in a very different world.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Sources: Bloomberg, Barclays, Capital Economics, Federal Reserve Bank of St. Louis, High Frequency Economics, Federal Reserve Board, ISI, JP Morgan, Strategic Insights, Mainly Macro, Sentinel Asset Management. Inc.

© Sentinel Investments