By Nandini Ramakrishnan, Global Markets Strategist, JP Morgan Asset Management
Investors have turned to high yield debt as an income supplement to record low government bond yields. But with the US Fed poised to raise rates for the first time in a decade next month, can HY still play that role?
The yields available from high yield debt have risen in over the last 12 months in Europe and America, prompting the question of whether a buying opportunity has opened up for investors.
There is no doubt where the main stress is located, and hence where yields have risen the most: energy. As US oil production rose in recent years, firms in the industry issued significant amounts of high yield paper.
In fact, the amount of outstanding debt in the JP Morgan US HY index that was made up of energy issuers peaked in autumn of 2014, right as the oil price started to settle at its current lows. The decline in the oil price has placed many of these firms under financial stress. Default is a real possibility in many cases, and the price of the bonds has fallen significantly, leading to a surge in their yields.
But, as the chart below shows, the recent sell-off has not been confined to just the energy sector. Yields have risen across all industry groups in both the US and Europe. Beyond the energy sector, fundamentals in both Europe and the US suggest the whole of the universe has been unduly punished for the sins of the few.
The lifeblood of credit sustainability is having the funds to pay the coupon on the debt and to reduce the need for further leverage. In Europe, high yield issuers are at last experiencing accelerating revenue and earnings growth. Earnings growth of 10.8% year over year puts them in a good position to service their debt.
And accommodative monetary policy, a weaker currency, lower energy prices and a healthier banking sector can support further growth in the region. We expect these factors to remain in place and a gradual recovery to continue in coming quarters. This underpins our assessment that reduction in resources available to service the debt should not trigger a sudden increase in defaults.
From a sector perspective, there are fewer energy companies in the European index than in the US one, and beyond the energy sector, most parts of the market do not look stressed. Industrials and telecommunications have high leverage indicators, but the former’s earnings growth and the latter’s earnings stability mean their debt burdens look manageable. Like oil & gas, construction & materials is seeing a sharp decline in earnings but has low leverage overall, so we do not see immediate default risk at the sector level.
In the US, meanwhile, fundamentals also look good, but are in more mature state of play. The expansion of revenue and earnings is cyclical, and because the US is further along in its economic cycle, we would expect earnings and revenue growth to have peaked here before Europe.
Earnings growth is 13.8%, higher than in Europe, but looks past its peak. However, although the US is more advanced in the cycle than Europe, we do not believe it is approaching the end. Even if the Federal Reserve begins to raise short-term interest rates, both monetary and fiscal policy conditions are likely to remain supportive of growth for a number of quarters.
Add to that the strength of the consumer and a recovering housing market, and we believe the US economy has a number of years to run, allowing revenues to trend higher and debt repayments to continue.
As the Fed prepares to play the Grinch and begin to withdraw the ultra-accommodative policy that has lifted risk assets in recent years, high yield still has plenty to offer investors who will need to keep working hard to find income for the foreseeable future. The important thing will be to be selective, and to choose managers with the ability to avoid stressed sectors and struggling issuers.”