The global high yield market delivered a notably strong performance in 2012, with total returns of 15.6% in the U.S. and 27.1% in Europe, according to BofA Merrill Lynch’s U.S. High Yield and Euro High Yield Indexes. Within the index holdings, a budding housing market recovery translated into the highest gains for the financial, real estate and building materials sectors in the U.S., with total returns exceeding 25%. In Europe, the financial sector was the best performer with a 46% total return, following policy-induced market stabilization in late 2011 and then again, during the summer of 2012.
Given the broad-based nature of the 2012 rally, yields and spreads are now in a narrower band than they were at the beginning of 2012 and 2009 (see Figure 1). 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. With an average price of $105.13 as of 31 January 2013, almost 82% of U.S. high yield bonds that have call options (72% of the total high yield market) are currently “trading to call date” – using the call date as the assumed maturity date − which is very near the historical high, as illustrated by Figure 2.
Against this backdrop of tighter yield dispersion and limited price upside, investors may want to tread with caution. We believe that to outperform versus the broader high yield indexes, avoiding potential downside may become at least as important as trying to capture any potential upside. As Figure 3 shows, as much as 57% of the average overall high yield market spread is now compensating investors for average historical credit losses, while less than half (47%) is the “excess spread” that compensates investors for the volatility and illiquidity associated with the asset class. This excess spread, or cushion, was as high as 61% at the start of 2012. Thus, as the market has rallied and spreads have compressed in the past year, credit and security selection are becoming increasingly critical: The room for error is becoming proportionally smaller. This is especially true further down the quality spectrum, as triple-C rated spreads are almost entirely compensating for historical default losses, with almost no excess spread cushion, as shown in Figure 3.
Given global central banks’ commitment to easy monetary policy, near-term default rates (and related default losses) may remain below historical averages, and in that case, Figure 3 may be understating the excess spread cushion embedded in current yield spreads. Indeed, in the most recent default loss data available, Fitch Ratings puts high yield market credit losses at only 90 basis points (bps) for 2012 − compared with the historical average of 283 bps, provided by Moody’s Investors Service and shown in Figure 3.
A closer look at new issuance
Where will future high yield investment opportunities come from? Given the record $364 billion in global high yield new issuance in 2012 (which was 26% of the global high yield market size at the beginning of 2012), it may be instructive to look at which direction the new issue market may take in 2013.
While almost 54% of 2012 new issue supply went toward refinancing existing debt, we have reason to believe refinancing-related volume may be lower going forward. Loan refinancing as a percentage of total new issuance has dropped steadily from a high of 43% in 2009 to 25% last year, and a resurgent loan and CLO (collateralized loan obligation) market means bond-for-loan take-outs are likely to be an even smaller proportion of new issue volume for 2013.
Instead, we see three important sources of 2013 supply: issuance from European companies looking to access the U.S. dollar market for the first time; corporate merger-and-acquisition (M&A) activity, including leveraged buyouts (LBOs); and debt-financed shareholder-friendly activity, including share buybacks and dividend recapitalizations. Let’s address them one by one.
- European issuance. Approximately 9% of 2012 new U.S.-dollar-denominated issuance came from European-domiciled issuers, many of whom were accessing the U.S. high yield market for the first time in an effort to diversify their financing sources away from European financial institutions. While the U.S. market was generally receptive, domestic investors demanded bigger new issue price discounts – and higher yield spreads − from these issuers compared with their U.S. counterparts. The additional spread premium was on average as much as 200 bps (versus U.S. issuers of similar credit quality) during the second half of 2012.
- Merger-and-acquisition activity. M&A and leveraged-buyout-related new issuance accounted for 17% of new supply last year, well below the peak of 47% in 2007, but a steady increase since the low of 7% in 2009. Easy central bank monetary policy has been instrumental in pushing yields in the high yield sector near all-time low levels such that they are now well below enterprise cash flow yields, as illustrated in Figure 4. In simpler terms, this means on average, high yield companies can finance their debt at a much lower rate (about 6% market yield as depicted in Figure 4) than the cash flow yields of their assets (more than 12% using EBITDA as a proxy for cash flows). In a slow-growth world − what we at PIMCO dub the “New Normal” − where central banks are committed to suppressing volatility, use of debt for corporate activity such as acquisitions and leveraged buyouts by private equity firms is likely to increase going forward.
- Shareholder activity. The low cost of debt financing is also why we expect increased equity monetization in the form of debt-financed share buybacks and dividend distributions going forward. Such transactions typically result in higher leverage and associated lower credit quality. We already saw signs of this in the second half of 2012 – when triple-C-rated issuance made up 11% of new issue volume, almost double the 6% seen during the first half of the year.
Taken together, tighter spreads, narrower yield dispersion, increasingly limited upside and the potential for future re-leveraging activity warrant additional caution when approaching the high yield asset class. Still, from a strategic perspective, given its income-generating potential (due to its relatively high current coupon compared with other credit spread products), overall lower volatility compared with equities (in both U.S. and global indexes) and limited near-term default outlook, we think high yield should continue to be part of a diversified asset allocation.
To summarize, the strong 2012 rally in high yield bonds has paved the way for a more cautious approach in 2013. Credit selection is likely to assume increasing importance as lower yields provide less compensation to investors and leave less room for error. Likely pickups in LBO or acquisition-related financing activity, as well as European refinancings, could provide higher-yielding opportunities, but with potentially higher risk.