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Andrew R. Jessop, Hozef Arif
It is no secret that global high yield markets continue trading near their all-time low yields that were reached in May 2013. With average yields at 5.39% for the U.S. and 3.77% for Europe (as measured by BofA Merrill Lynch U.S. High Yield and European Currency High Yield indexes as of 14 March 2014), we are still looking at a “medium yield” more than a “high yield” bond market.
Narrow range of outcomes When assessing trends and opportunities in the high yield market, it is also instructive to look at the distribution of yields around the average to get a better sense for the range of outcomes. Although high yield bonds span a broad range of sectors, industries and individual credits, their yields today tend to fall within an increasingly narrow range – this implies high yield bonds (of all kinds) are trading at levels more similar to each other than they were in 2013 or in 2012. Figure 1 plots this yield dispersion (i.e., the percentage of the market that trades in a given yield range) for the U.S. high yield market.
Avoiding pitfalls and identifying rising stars Narrow dispersion is a major factor in high yield investing today: It means portfolio decisions that target outperformance should now be guided by avoiding the losers as much as by picking the winners. In addition, there are few total return opportunities still available to offset any potential widening in yields and subsequent underperformance from deteriorating credits. As a result, bottom-up credit analysis has become even more paramount.
At the same time, strategies for picking the rising stars should not be limited to BB/B rated companies with potential for upgrade to investment grade ratings, but also to CCC rated credits where agency ratings lag the improvement in the underlying credit profile. Figure 2 plots the yield dispersion for just the CCC segment of the U.S. high yield market. While CCCs have seen meaningful outperformance relative to the broader high yield market over the last couple of years, the yields in today’s CCC cohort are much more widely dispersed relative to the BB/B cohort. Careful credit selection and research can help identify improving credit profiles and upgrade candidates that are positioned to outperform their benchmark and provide alpha-generating opportunities. At the same time, given CCCs tend to be the most sensitive among high yield bonds to underlying equity valuations, many of these riskier credits now trade at yields too low for their credit profiles that may not be justifiable in the event of an equity market correction.
Prefer U.S. over Europe for total return opportunities in high yield today European high yield outperformed U.S. high yield in both 2012 and 2013, returning 28.5% and 10.3%, respectively, versus 15.6% and 7.4% for U.S. high yield (according to BofA Merrill Lynch indexes). But European high yield has also seen a more dramatic shift in recent months as spreads have fallen faster than their U.S. high yield counterparts. As a result, dispersion among European high yield is more constricted, and trades well inside U.S. high yield (Figure 3), further limiting total return potential versus U.S. high yield.
That said, investors may find select opportunities among first-time European issuers that are unfamiliar to the high yield market – meaning investors tend to demand higher yields to own them. As with higher-risk credits in the U.S., careful bottom-up credit research can help identify such opportunities in Europe as well.
Past performance is not a guarantee or a reliable indicator of future results. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The quality ratings of individual issues/issuers are provided to indicate the credit-worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively.
The BofA Merrill Lynch U.S. High Yield Index is an unmanaged index consisting of bonds that are issued in U.S. Domestic markets with at least one year remaining until maturity. All bonds must have a credit rating below investment grade but not in default. The BofA Merrill Lynch U.S. High Yield CCC and lower Index is a subset of the U.S. High Yield Index. The BofA Merrill Lynch Currency High Yield index is designed to track the performance of euro- and British pound sterling-denominated below investment grade corporate debt publicly issued in the eurobond, sterling domestic or euro domestic markets by issuers around the world. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO.
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