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Andrew R. Jessop, Hozef Arif
The global high yield market saw robust performance in 2013, with total returns of 7.4% in the U.S. and 10.3% in Europe. Coupon carry combined with a low default environment drove much of the performance, in our view. In the U.S., average yields neither exceeded nor disappointed expectations, ending the year close to where they began, while European high yield outperformed U.S. high yield for the second year in a row as the region finally showed signs of emerging from recession. (All data is from BofA Merrill Lynch’s U.S. High Yield and European Currency High Yield indexes.) We believe that as the economic recovery gains a firmer footing and financial conditions remain favorable for issuers, the coming year could offer attractive high yield opportunities.
In high yield today, “D” has more to do with duration than defaults Default rates and credit losses remain below their long-term averages, with global defaults at 2.7% by issuer and 1.6% by par in November 2013, according to Moody’s, and we believe default rates will remain low in 2014 and 2015 as well. Several factors support this view: The global growth outlook for 2014 has improved, financial conditions generally remain favorable and issuers have very limited refinancing needs – under 10% of all high yield bonds are slated to mature during the three-year span between 2014 and 2016, according to BofA Merrill Lynch.
Duration concerns were front and center for the high yield market in the summer of 2013 when the asset class, for the first time since the mid-1990s, showed a positive correlation with Treasuries – that is, high yield spreads widened in a duration sell-off as opposed to acting as a cushion to absorb the duration as they typically do (see Figure 1). However, during the most recent rate sell-off in November and December 2013, high yield returned to a negative correlation with Treasuries.
Seek better convexity in a “medium yield” market At the outset of 2013, the yield offered to many investors and tight spread conditions led us to suggest the term “medium yield” might better describe the high yield market (see our February 2013 Viewpoint: “‘High’ Yield or ‘Medium’ Yield? – We Report, You Decide”). And indeed the high yield market hit an all-time low yield of 4.99% on 9 May 2013 (as measured by the BofA Merrill Lynch U.S. High Yield Cash Index). Notwithstanding the subsequent volatility during the summer, yields have remained in a narrow range in both the U.S. and Europe, very similar to what they were a year ago. In addition, most high yield bonds have call options that enable the issuers to retire the bonds before maturity (i.e., negative convexity), limiting their upside potential.
If rates volatility is contained, we expect 2014 to be another “coupon-focused” year, with returns generally dominated by carry as opposed to price appreciation. We believe one of the most important factors in determining performance potential will be exposure to better convexity, which can take several forms: potential upside from price recovery in high quality bonds trading below par, sectors with favorable industry dynamics and positive event risk from mergers and acquisitions (M&A) or equity offerings, or participation in new issues that are priced at an attractive concession to the secondary market.
Potential upside from price recovery. During the summer 2013 sell-off, many of the high rated (BB–B) bonds that were issued at all-time low coupons during the earlier part of 2013 came under the most pressure, with the result that 24% of nonstressed BB–B rated bonds (source: BofA Merrill Lynch BB–B U.S. High Yield Index, using 500 basis points as a cutoff) were trading below par by 30 June 2013, up from 4.1% at the end of 2012 (this figure has since decreased to 16.2% at the end of 2013).
In today’s market, we find lower-priced BB–B bonds attractive for several reasons: 1) Their below-par price helps mitigate the negative convexity from the call option compared with bonds that trade at a premium to the call price, 2) Many of these bonds are exposed to the potential for price upside from change-of-control put options – meaning if the company were to undergo an M&A or a leveraged buyout, investors have the option to sell the bonds back to the company at 101% of par value and 3) Lower dollar price also provides some degree of downside risk mitigation in the event things go wrong, as recovery rates are based off a par claim.
Industry dynamics and positive event risk. In 2013, high yield companies in a range of sectors were able to price their initial public offerings (IPOs) against a backdrop of supportive stock market valuations; examples include Hilton (lodging), Aramark (services), Taminco (chemicals) and HD Supply (building materials). If equity valuations remain supportive into 2014, they may continue to provide an avenue for exit for many private equity sponsors’ existing leveraged buyout (LBO) deals. We expect equity monetization will remain a key theme going forward, especially for lower-rated credits that are more sensitive to equity market valuations.
Turning to upside event risk from M&A activity, the healthcare sector offers an example: Over the past decade, this sector has benefited, broadly speaking, from its relatively non-cyclical profile and the aging population demographics in developed markets. Healthcare reform is also expected to support earnings growth for the hospital sub-sector in 2014 and 2015. Within the high yield healthcare universe, we see investment opportunities being created by generally improving equity multiples and also the recent acceleration in strategic takeover activity by larger healthcare companies. The latter facilitated an early exit strategy for several high yield issuers in 2013 (such as Warner Chilcott and Vanguard Health), with a resulting upside for their bonds, which outperformed the similarly rated broader high yield markets for the year (markets proxied by the BofA Merrill Lynch U.S. High Yield BB–B index and B index, respectively; note Vanguard bonds were redeemed on 31 October following the merger). We expect this trend to continue in 2014.
Attractively priced new issues. Higher equity valuations also lead us to believe that new LBO activity, which was already at low levels in 2013 (at 4% of total high yield issuance for the year based on Bank of America Merrill Lynch data, excluding the two large and idiosyncratic LBOs of Heinz and Dell), will remain subdued in 2014. Heinz and Dell were relatively large investment grade issuers going private, a rarity in the high yield market, especially after 2008.
However, we do expect more investment grade issuers to provide meaningful new supply to the high yield market in the coming year, as corporate actions or developments potentially lead to a ratings downgrade and these issuers migrate to the high yield range. Whether the downgrades are due to active releveraging (such as ADT), operational deterioration (such as Telecom Italia) or corporate M&A (potential for which exists in the U.S. cable sector), the overall result is likely to be a notable expansion of the high yield market. In fact, the ratio of these kinds of “fallen angels” (companies being downgraded by rating agencies from investment grade to high yield) to “rising stars” (companies being upgraded from high yield to investment grade) has increased steadily over the last three years: In 2011 we saw essentially the same number of downgrades as upgrades, but by 2013 there were 2.4 times as many downgrades as upgrades (source: Bank of America Merrill Lynch). We expect this significant trend to continue into 2014 and provide additional new high yield supply.
Based on our observations, M&A activity, again with the healthcare sector as a prominent example, is also generating attractive new supply as large, liquid deals are financed in the high yield market. This is also likely to continue in 2014.
We believe the “medium yield” market is among the reasons for this phenomenon, as the cost to finance debt is still relatively low by historic standards and well below the cash flow yield generated by the corporate assets (using EBITDA as a proxy for cash flows, we define cash flow yield as EBITDA divided by enterprise value). This notable difference between cash flow yield and high yield debt financing was off its peak in 2012, yet remains at a high level compared with historic data (see Figure 2). We believe this will continue to be an important factor as companies evaluate use of debt to make what they perceive to be equity-enhancing acquisitions, dividends or share buybacks.
High yield in 2014: expect returns dominated by coupon carry To summarize, we believe 2014 could be another year of returns that are dominated by carry against a backdrop of a stronger growth outlook, low default environment and generally supportive capital markets conditions. We expect new issuance proceeds to further diversify away from refinancing activity into more corporate M&A and shareholder-friendly transactions.
Investors should consider positioning for better convexity via exposure to sectors with favorable industry dynamics and positive event risk from M&A or equity offerings, potential upside from price recovery in high quality bonds trading below par and exposure to select new supply from former investment grade companies.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. 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. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Investments in companies engaged in mergers, reorganizations or liquidations may involve special risks as pending deals may not be completed on time or on favorable terms. Investors should consult their investment professional prior to making an investment decision.
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 issuers referenced are examples of issuers PIMCO considers to be well known and that may fall into the stated sectors. References to specific issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold securities of those issuers. PIMCO products and strategies may or may not include the securities of the issuers referenced and, if such securities are included, no representation is being made that such securities will continue to be included.
This material contains the opinions of the author 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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