December 13, 2017
Fixed Income: Evaluating the Next High Yield Cycle
The impact of credit growth, globalization, innovation and regulation.
Investors tend to use history as a guidebook when allocating capital and evaluating whether markets are cheap or expensive. The changes occurring in today's high-yield markets, however, indicate that history may not be a perfect guide for investors over the next credit cycle. The influence of market technicals can be expected to rise in importance and will likely contribute to higher levels of volatility. In addition to explosive growth in global debt issuance, there are new issuers, new rules and a wider variety of investors with a range of objectives. We view these developments as important and perhaps underappreciated factors that should be a part of a comprehensive investment strategy for managing risk and finding opportunities over the next high-yield cycle.
Credit markets have grown in size, breadth and geographic scale since the global financial crisis, with global credit and global high yield increasing 133% and 145%,1 respectively, over the past decade. In addition, the non-US representation in the Global High Yield Index has increased from 25% to 40%2. Accompanying that growth has been innovation and broader usage of a range of investment vehicles such as exchange-traded funds (ETFs), credit default swaps (CDS), collateralized loan obligations (CLO) and total return swaps (TRS). In addition to growth and product innovation, regulations following the global financial crisis, such as Dodd-Frank, the Volcker Rule and MiFID II are also taking shape and likely to weaken liquidity in high-yield markets going forward.
The changing risk profile of high yield means future market cycles will increasingly be driven by technical, in addition to fundamental, events. Below, we review some of the changes and risks investors should consider in future credit cycles.
What fueled the growth of the asset class? In an economic environment generally characterized by low growth, inflation and volatility, the current credit market expansion might be interpreted as a "golden age" of credit, fueling a rise in both high-yield supply and demand. On the supply side, historically low rates have attracted plenty of corporate borrowers seeking to re-lever their balance sheets post-crisis. The debt has been put to work largely in the form debt-financed merger and acquisition activity as well as share repurchases and dividend increases.
On the demand side, plenty of new, non-traditional buyers of high yield entered the market as sovereign yields have hovered near all-time lows —and even fallen below 0% in many instances — for several years. Central bank intervention in global bond markets has "crowded out" many traditional fixed income investors, driving them to seek yield and income from non-traditional and riskier asset classes such as high yield, emerging markets debt, leveraged loans and private credit. It is not surprising that investor demand has been persistent given the lack of opportunities in higher-quality assets.
Compositional changes in markets and cycles can cloud historical comparisons, and the impact of globalization on the next credit cycle could be quite profound. We have seen an expansion of global high-yield debt issuance, particularly in European and emerging markets during this cycle (as shown in Exhibit 1). The impact of this global expansion will likely be felt over subsequent cycles, embedding new systematic risk factors for high-yield spreads. These include currency risks — in the form of company-level mismatches as EM issuers generally do not fully hedge hard currency borrowings — and insolvency risks such as more uncertainty in financial restructuring because of inconsistent priorities and a lack of focus across jurisdictions. Although data are spotty at this point, indications are that default recovery values are falling in emerging markets as the universe becomes more diverse.
There are a few basic ways to view bond issuers that straddle the high-yield and investment grade-fence in fixed income. The group classified as "fallen angels" are issuers that are declining in credit quality for a variety of reasons. These issuers can fall from investment-grade to high-yield status, losing value along the way. On the other hand, there are the "rising stars" or issuers that are improving in credit quality, and generally speaking gaining in value as they move up the ratings quality scale. In Exhibit 2, we illustrate case studies of fallen angels in the high-yield market and how that has influenced the composition and risk profiles of certain sectors or regions in periods where there has been a lot of ratings activity. We looked at the benchmark weights pre- and post-downgrades – for example, autos went from less than 3% to nearly 7%, there was not much of a high-yield financials universe and energy endured some significant downgrades to post some meaningful growth. In the Global High Yield benchmarks, when the Russian and Brazilian sovereigns were downgraded, it resulted in downgrades for the entire corporate universe in Russia and Brazil (similar changes have also occurred in Turkey and South Africa). In summary, these examples highlight how benchmark risk units can be influenced and changed by certain actions.
This dynamic is an important supply characteristic that has evolved over the current credit cycle. The deterioration of quality in the investment-grade market is prevalent and a significant risk to the high-yield market. Currently, BBB-rated bonds are equal to 45% of the entire outstanding high-yield market, which has increased from 30% a decade ago.3 Since BBB is the lowest investment-grade bond rating, the risk is that many poor credits will fall, like angels, from the investment-grade into the high-yield universe. We believe that fallen angels are a risk to the high-yield market, especially to passive investors. When downgrades occur, the yields of fallen angels tend to rise dramatically while their prices decline. We think managing volatility associated with fallen angels as they enter the high-yield index will be among the significant challenges facing high-yield investors over the next cycle.
Another challenge for investors in the next cycle will be contending with an investor base that may be more fickle than in the past. The global hunt for yield post–financial crisis has altered the high-yield investor base and broadened the array of vehicles used to gain exposure to the asset class, neither of which enhance the stickiness of exposures. More investors are accessing high-yield investments through different vehicles, such as CDS, TRS and CLOs. There has also been significant growth in the high-yield ETF market. Underlying high-yield volatility has increased slightly during the past five-plus years as ETFs have experienced rapid growth and their influence has increased in the market. While volatility created by ETFs might be painful over the short-term through intra-day trading anomalies, it may also create idiosyncratic valuation distortions for active managers to capture.
Regulators responded to the global financial crisis with sweeping changes for both dealers and investors, including constraints on Fed-regulated banks, Dodd-Frank and the Volcker Rule, which prohibits proprietary trading. Interestingly, the Volcker Rule was found to have had nearly the same impact on liquidity that the financial crisis had.4 In normal environments, liquidity can explain one-third of spread variation, and in stressed periods liquidity impacts can rise to nearly one-half of the spread variation. We think this asymmetry of outcomes is a vital consideration for high-yield investors. Sell-side credit research business models are expected to evolve as a result of the second tranche of European regulations labeled MiFID II (Markets in Financial Instruments Directive), as shown in Exhibit 3. Key objectives of the add-on EU legislation include increasing clarity and competition in the trading process and enhancing transparency in research costs. MiFID II is expected to result in less sell-side research coverage of companies, which potentially increases pricing inefficiencies and idiosyncratic volatility, as information may not spread through the markets. The bottom line is that in-house fundamental research and active security selection may have increasing opportunity to add value if company coverage decreases.
Historically among the most volatile fixed income asset classes (source: Bloomberg), a number of influences have come together in recent years that may further increase the volatility of the high-yield asset class. Future credit cycles may not conform to historical patterns due to the growth and diversity of global credit markets, financial innovation and regulatory changes. Investment and risk management processes need to adapt to these changes and account for systematic risks (including technical) in addition to company-level credit risks. Finally, although volatility may increase over the short term, as we look ahead we believe investors with a long-term horizon may ultimately benefit from the new challenges facing high-yield investors.
1 Bloomberg. As of September 30, 2017.
2 Over the 10-year period ending August 31, 2017. Source: BAML Global High Yield Constrained Index. Constrained Index (USD hedged) contains all securities in the BofA Merrill Lynch Global High Yield (USD hedged) Index, which tracks the performance of USD, CAD, GBP, and EUR denominated below investment grade corporate debt publicly issued in the major domestic or Eurobond market, but caps issuer exposure at 2%.
3 As of August 31, 2017. Source: Barclays US Credit Index. The Barclays U.S. Credit Index is the credit component of the Barclays Capital U.S. Aggregate Bond Index, which is a broad-based bond index comprised of government, corporate, mortgage and asset-backed issues, rated investment grade or higher, and having at least one year to maturity.
4 Bao, Jack, OHara, Maureen and Zho. Alex, "The Volcker Rule and Market-Making in Times of Stress," Federal Reserve Board, 2016.
The views expressed are those of David Cole and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
This content is directed at investment professionals only.