US high yield: The strong alpha opportunity in fallen angels
Investors in US high yield have had to endure elevated volatility over the past 18 months, as global economic weakness and continued commodity turbulence weighed on the asset class. The first four months of 2016 were a case in point, with the sharp falls experienced at the beginning of the year more than reversed by the strong rally for risk assets in recent weeks.
Despite the powerful rally, we continue to be optimistic on the prospects for high yield and maintain our belief that current valuations, excluding the commodity-related sectors, are compensating investors for default risk. While growth in the US has moderated, we expect the economy to continue expanding in 2016. Inflation is also likely to remain relatively benign and the Federal Reserve will take a very measured approach in terms of normalising monetary policy.
While commodity-related sectors are likely to drive the majority of the increase in US high yield defaults in 2016 and 2017, we believe overall credit fundamentals remain reasonable and defaults outside of these stressed sectors will remain well below historical averages.
The standout performance of fallen angels
One area of the market we are focusing a lot of current attention on is in ‘fallen angels’, particularly as a swathe of commodity-related credits are being stripped of investment grade ratings. We believe a few gems are getting caught in the fallout.
Fallen angels have been the stand-out performers in the high yield universe in recent years. Over the five years to the end of 2015, the Bank of America Merrill Lynch U.S. Fallen Angel High Yield Index outperformed broader high yield indices by well over 2.5% annualised. Additionally, it did so with about 90% of the volatility.
These results are intuitive. Most fallen angels are bonds issued by good quality, investment-grade companies going through short-term difficulty. These securities often end up back in the investment grade world, which accounts for the lower risk.
In addition, by the time these credits come into high yield the downgrade is already priced-in, due to forced selling by investment grade portfolios. High yield managers are able to obtain the bonds disproportionately cheap, which accounts for the higher return.
Almost a record year for downgrades already
The all-time high for the dollar amount of bonds downgraded from investment grade to high yield in a single year unsurprisingly came in 2009, at $150bn globally. The total for 2015 fell just short at $143bn. Remarkably, the first quarter of 2016 saw $140bn of downgraded bonds. It means 2016 is already the fourth-highest year on record for fallen angels – with nine months still to go.
Examining fallen angel performance over recent years, Bank of America Merrill Lynch found 60% of the current universe stabilised at BB+ and 88% kept within the BB band, with only 4% falling to CCC+ or below. Many fallen angels immediately engaged in deleveraging in a bid to recover an investment grade rating.
Some caution is warranted, as the current wave of downgrades is distinctly sector specific: 20 of the 26 new US fallen angels downgraded in Q1 were issued by energy or metals and mining companies. These sectors are set to account for the vast majority of defaults expected this year. The extent these bonds stabilise is likely to depend on the trajectory of oil prices.
Nevertheless, the rally in high yield and energy since mid-February has already rewarded investors in fallen angels, with the fallen angel index generating twice the return of broader high yield in Q1. In February, some energy sector names traded at 70-80c on the dollar – prices equivalent to other BB-rated names – but not reflective of the higher-quality fundamentals in fallen angels. We exploited this anomaly by adding some Canadian energy-sector issues in Q1.
Alongside our core late-stage credit cycle strategy of seeking out defensive value – in sectors such as healthcare and gaming – we expect fallen angels to be a rich and attractive pocket of opportunity to add alpha through 2016.
Thomas O’Reilly is portfolio manager of the £5.1bn Neuberger Berman High Yield Bond Fund, which will reach its 10-year track record in May.