Fixed Income Commentary: High Yield Takes a Pause
TCW Investments
By Gino Nucci
June 23, 2011
Fixed Income Commentary: High Yield Takes a Pause
Fixed Income Commentary
June 21, 2011
Market Overview
Fears of slower economic growth ("fundamentals") and bloated bank/broker balance sheets ("technicals") led to increased volatility in the corporate bond market for the second week in a row. The prospect of weaker than expected corporate earnings, which is common following downward revisions to GDP, and brokers reducing balance sheet risk (inventory from retail outflows) led to a -0.57% return for high yield bonds in the week ending June 17. The combined conditions of poor fundamentals and technicals left few buyers of risk and pushed spreads to near +600 basis points over Treasuries, which is typically the maximum spread observed in a non-recessionary period. In fact the only time spreads have been wider than +600 bps during a recovery over the last 25 years was in October 1998, just prior to the Long-Term Capital bailout. Given that the current credit cycle is but 30 months old (as compared to the more typical 60+ month cycle lifespan), TCW views current conditions as reflective of a mid-cycle correction and not a harbinger of a return to recessionary conditions. As such, current high yield bond spreads are attractive.
High Yield Spreads
High Yield Spreads vs. Peak
In fact, current spreads are in the fourth highest quintile of observations over the last 25 years. Given today's starting spread near +600 bps, prospective excess returns (total return relative to Treasury bonds) over the subsequent three years have averaged 4.65% annualized, and are rarely negative outside of a recession. According to Barclays research, these episodes of forced selling and multi-day losing streaks are typically followed by above average returns over the subsequent three to six months. This is not uncommon during a mid-cycle pause and also occurred as recently as 2005 when Ford and GM were downgraded to high yield and spreads widened out from both technicals (huge supply of bonds entering the index) and a soft patch during the recovery.
Forward Return Performance Following Multi-Day Losing Streaks (2001-11)
After May’s record shattering new issue volume, issuance in the leveraged finance market finally took a pause. Amidst the volatility, only six high yield new issues totaling $1.6 billion priced last week while $4.2 billion priced in the loan market. Year to date, over $175 billion and $164 billion of high yield bonds and loans, respectively, were issued. Thus, last week’s bond volume was roughly just 20% of the average for 2011. Retail outflows continued for the third consecutive week as $1.6 billion was redeemed from high yield mutual funds, the third highest total on record and the largest since $1.7 billion for the week ended May 12, 2010. CCC-rated bonds declined the most at -0.99% and now returns for BB, B and CCC-rated bonds have all returned approximately 4-5% year to date. While the Distress Premium (CCC/B spread) has widened out over 50 bps recently, valuations remain unattractive for distressed bonds. According to Barclays, the percentage of bonds trading above their next call price dropped from 44% in early May to 29% today. Therefore the 2-point decline in high yield prices has reduced the degree of negative convexity in the market and has marginally improved the risk/reward of owning a high yield bond above par.
Spreads/Yields
Mid-Cycle Spread Widening
Legal Disclosures
For Information Only
This publication is for general information purposes only. Past performance is no guarantee of future results. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision.
Subject to Change
Any opinions expressed are current only as of the time made and are subject to change without notice. TCW assumes no duty to update any such statements. The views expressed herein are solely those of the author and do not represent the views of TCW as a firm or of any other portfolio manager or employee of TCW. Any holdings of a particular company or security discussed herein are under periodic review by the author and are subject to change at any time, without notice. In addition, TCW manages a number of separate strategies and portfolio managers in those strategies may have differing views or analysis with respect to a particular company, security or the economy than the views expressed herein.
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