The combination of subdued economic growth and central bank policy has driven down yields of developed government bonds to historical lows. Currently, over $10 trillion of government bonds are trading with negative yields.
One area that continues to offer investors some yield is the US high yield bond market. Here, investors can still pocket a yield in excess of 6% – not bad in today’s yield starved environment.
The Goldilocks zone
The major risk to our view would be the economy freezing over and default rates increasing. However, we believe that the US economic picture is looking benign, with growth ticking along nicely. This should help keep defaults rates low.
Any investment in high yield bonds is subject to the risk of corporate defaults. To get a handle on the impact of this, our 10 year forecasting process makes an explicit allowance for these defaults.
This long-term approach suggests returns of around 4.5% per annum for the next 10 years, after defaults are factored in. This may not sound like much, but in a world where cheap assets are hard to find, gaining exposure to one that is not overtly expensive is certainly a good start. Furthermore, if we are right about the benign economic cycle, defaults over the next 1-2 years should come in even lower than we have assumed, creating further upside potential.
Figure 1: It is hard to find assets that are just as attractive as they were 5 years ago, but US high yield is one such example.1
The second major risk would be the Fed changing its tone and starting to hike interest rates aggressively. We don’t believe this is likely, for the reasons highlighted in the first paper in this series.
This is almost the goldilocks zone for US high yield. An economy that is not hot enough to generate aggressive rate hikes, but not cold enough to generate defaults.
Does the relationship with the energy sector threaten returns?
A worry for some investors is the relationship between the US high yield market and US shale energy companies, who are suffering from the low oil price. Indeed, the US high yield market does have a 15% energy-related component, and much of this linked to the fortunes of the shale names.
However, while it is true that over the past few years some US energy companies overstretched themselves, much of these past excesses have now been shaken out of the market. In 2016 we have already seen a number of high profile defaults, including Chesapeake and Sandridge Energy. We believe the worst is likely behind us.
Nevertheless, we can strip out the apparent cheapness that is associated with the energy component of the US high yield market, and focus only on the remaining 85%. As shown in figure 2, if we do this the yield on offer is still attractive – in excess of 6%, it’s only slightly less than the total market.
In other words, the value in the US high yield market is much broader based than just the energy sector.
Figure 2: While the energy sector does account for some of the market’s cheapness, there is still decent value in the other 85% of the market.2
Corporates have not (yet) become too leveraged
A common criticism of the US high yield market is that it’s overleveraged. As the market cycle develops further this critique will become more valid, but right now we don’t believe this is true. In fact, leverage levels are only modestly creeping up. Adjusting the level of spreads for the slight change in leverage does not yet raise alarm bells.
Figure 3: Adjusting the high yield spreads for the recent changes in leverage still suggests there is value.3
Investing with conviction
We are very much alive to the risks of investing in the US high yield market, but believe they are overstated by the market. Indeed, in this ultra-low interest rate environment, our analysis suggests that the market is attractive, because:
- Higher yielding bonds will become increasingly favourable the longer ultra-low interest rates persist.
- The US economic recovery is healthy. It is strong enough to keep default levels modest, but gradual enough not to create inflation.
- High yield spreads remain above their historical levels, even when adjusted for leverage, or after stripping out the energy component.
Against this backdrop, a yield of over 6%, and a total return expectation of around 4.5% when defaults are allowed for is a very attractive proposition, in a world of ultra-low interest rates.
The above explains why in the Baring Dynamic Asset Allocation Fund, and the Baring Multi Asset Fund, we have allocated over 20% to US high yield bonds.4
Michael Jervis is an investment manager with the Baring Multi Asset Group at Baring Asset Management in London