It might seem an odd time to make a case for high yield debt. After all, spreads have generally widened over the last 18 months, with yields surpassing 8% in late November – levels that have not been sustained since the European sovereign crisis in 2011. The widening reflects large outflows, concerns over exposure to the energy sector and uncertainties about global growth. Nonetheless, in our view, the outlook for the high yield market, particularly in the U.S., has become more positive.

A bit of perspective is needed to understand why. First, consider the portfolio-level benefits that high yield bonds have tended to deliver: the potential to reduce risk if allocations are funded from equities; the potential to enhance yield if allocations come from high quality bonds; and the potential to improve a portfolio’s overall risk/return given high yield’s low correlation to most other asset classes.

The case for high yield bonds over equities is particularly compelling because the recent slowdown in corporate profit growth has led to lower free cash flows and the sell-off in credit markets has lifted yields from U.S. high yield bonds to the 6%–8% range investors typically target for equity returns. As Figure 1 shows, yields on U.S. high yield bonds have been increasing and reached over 8% in late November, which has widened the gap versus the S&P 500 free cash flow yield.

Coupons from high yield bonds also have an advantage over dividends from stocks: Coupons have tended to be higher and more stable and are a contractual obligation, not discretionary. Historically, high yield bonds also have provided better downside protection, delivering equity-like returns with significantly less volatility and drawdowns.

As mentioned above, high yield bonds can also be yield-enhancing. High yield spreads from developed market companies are more than 3.5 times those of global investment grade companies.

Finally, high yield bonds have had a low correlation to other asset classes, particularly to government bonds, making them an attractive portfolio diversifier. For example, high yield bonds have been negatively correlated to Treasuries: They have historically delivered positive returns when Treasury yields rose.

Fundamentals, technicals and valuations
When assessing the outlook for high yield bonds, we evaluate the three pillars of the asset class: fundamentals, technicals and valuations. Overall, we are constructive on the high yield market as the economic expansion should continue to support a low default environment, outside of higher risk credits in energy- and commodity-related sectors. Valuations are pricing in a pickup in defaults, which in our view has created opportunities for investors to add select credit risk.

Fundamentals

Credit markets tend to do well in economic expansions and poorly in recessions. In the U.S., real economic growth of 2.25%–2.75% (our outlook for the 12 months ending September next year) is credit’s sweet spot – not so hot as to encourage unsuitable debt levels but not so cold as to increase default rates. Balance sheets remain strong, and cash balances are relatively high.

Though we experienced a prolonged period of improving leverage metrics after the financial crisis, easier conditions in capital markets incentivized companies to issue more debt. Weakness in the energy sector exacerbated this trend as lower oil prices sharply lowered EBITDA (earnings before interest, taxes, depreciation and amortization) and increased leverage, especially among independent exploration and production and oilfield services providers. Headline leverage has increased for public high yield companies, but if commodity-related sectors are removed, leverage has remained relatively flat in the last couple of years for the rest of the market (see Figure 2). Also, interest coverage ratios remain at robust levels, especially outside of commodity-related sectors.

Albeit more of a backward-looking indicator, the 12-month trailing default rate of 2.3% is about half the long-term historical average. Headline default rates will increase in 2016 – Moody’s predicts over 3% – and if there is an accelerated level of restructuring in the energy sector, it will be even higher. Apart from commodity-related sectors, defaults are likely to remain stable and relatively low over the foreseeable future given the maturity profile of the market, where less than $90 billion of high yield bond maturities will come due through 2017. In addition, with higher-than-normal recoveries today, default losses are expected to remain near the 1% level for non-commodity-related sectors, which is favorable from a historical perspective.

Technicals

Technicals have played a larger-than-normal role in driving high yield performance so far this year, as we have seen large swings into and out of actively managed and exchange-traded funds (ETFs). Though there were large inflows in October, over the last few years there has been a significant amount of retail fund outflows that have wiped out a lot of the assets under management added since the financial crisis; most of the setback has come from non-ETFs, which have shrunk as ferociously as they expanded after the crisis. Therefore, a lot of fast money has been flushed out over the last three years. Given today’s attractive yields, we believe now may be an opportune time for institutional investors to increase their exposure to high yield. That said, retail flows will likely remain unpredictable as exogenous risks could affect investor sentiment.

Valuations

The factors that have boosted yields over the last few months have created attractive value for high yield bonds. High yield bond prices are now below par, which presents opportunities for price appreciation in addition to coupon income. Also, on a loss-adjusted basis that takes into account expected defaults and above-average recoveries, spreads are well above their historical average and, in our view, represent attractive value.

Spreads will likely remain volatile, but among select sectors they offer compelling value given the indiscriminant selling. Sectors outside of energy and metals and mining have widened by over 150 basis points since June 2014 (when oil began its decline) – even though the drop in commodity prices should have helped consumer sectors, which make up most of the high yield market.

Deeper dive into energy
Commodity-oriented sectors, which are heavily weighted in indexes, have been driving performance for the broader high yield market. Sentiment in the high yield energy sector has swung back and forth over the last year, affecting the wider high yield market to varying degrees. The market has been quick to identify likely restructuring candidates with around a third of the energy sector trading at distressed levels, compared with just 1% in June 2014. This represents about 4% of the overall universe of high yield bonds. Many of these distressed issuers are expected to default in the coming year but we do not expect spillover to non-commodity-related sectors as most issuers have sufficient liquidity over the near term.

Across our high yield portfolios, we have been and continue to remain underweight commodity-related sectors. We were underweight before the large drop in oil, but we may look for buying opportunities to reduce our underweight where asset quality provides downside mitigation and where companies may benefit from M&A opportunities should consolidation occur in the next 12‒24 months.

Portfolio implementation
Despite recent volatility, the case for high yield as part of a broader diversified portfolio is strong. The sector has consistently provided lower risk than equities and portfolio diversification benefits. We view the high yield market as attractive given improved valuations and the low defaults expected in non-commodity-related sectors. Specifically, we are finding numerous opportunities in the cable, health care and banking sectors. In our view, any continued spread widening or market volatility should provide attractive entry points for investors.

The Author

Andrew R. Jessop

Portfolio Manager, High Yield

Anna Dragesic

Head of Credit Product Management, Europe

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Disclosures

All investments contain risk and may lose value. 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. It is not possible to invest directly in an unmanaged index. Investors should consult their investment professional prior to making an investment decision.

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. ©2015, PIMCO.