The high-yield bond market has rallied sharply this year, which is great for high-yield bond investors. Unfortunately, the rally leaves some parts of the market vulnerable to a correction.
Here are two to watch: energy and retailers. Bonds in these two parts of the market have suffered price declines through the first seven months of the year, and risks remain for further potential declines. For investors who own or who are looking to buy individual bonds, we would exercise caution when investing in these parts of the market, in case their risks lead to price declines ahead.
Not all high-yield investments are created equal
Source: Bloomberg. Returns from 12/31/2016 through 7/31/2017. Total returns assume reinvestment of interest and capital gains; price returns just represent the change in price. See disclosures for index definitions. Past performance is no guarantee of future results.
Energy: Defaults in the rear-view mirror, but concerns linger
While this may seem like old news, energy and other natural resource issues remain risky, in our opinion. Oil prices remain low despite being up nearly 100% since the lows of early 2016.
The low price of oil has sent shockwaves through the high-yield corporate bond market over the past three years, as corporate defaults piled up. According to credit rating agency Standard and Poor’s (S&P), the trailing 12-month speculative-grade default rate hit a recent peak of 5.1% this past December, up from a post-crisis low of just 1.4% in July 2014. The default rate has modestly declined since then, but with 78 defaults over the past year and a half, energy and natural resource issues have accounted for more than half of the 136 corporate defaults in the United States.
The market lately has shrugged off the still-low price of oil, as compensation to hold high-quality energy bonds has plunged. The credit spread, or yield spread, is the additional yield that corporate bonds offer relative to Treasury bonds with comparable maturities. If an investment is perceived to be risky, investors tend to demand a higher credit spread to compensate for the greater risks. Beginning in late 2014 the prices of many high-yield energy bonds dropped sharply due to concerns about their ability to make timely interest and principal payments, sending spreads sharply higher.
Energy spreads have fallen sharply from their early 2016 peak
Source: Bloomberg, using monthly data as of 7/31/2017. “Energy issues” represents the energy sector of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index. Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan.
Those spreads have narrowed lately. While high-yield energy spreads are still slightly above the broad index, they resemble a more normal level today. The drop in spreads has affected the number of “distressed” issues as well. A distressed bond is one whose option-adjusted spread is above 1,000 basis points, or 10 percentage points. According to S&P, oil and gas has the second highest distress ratio, at 13.9%. In other words, 13.9% of the oil and gas high-yield bonds that S&P rates have spreads higher than 10%.1 This number is down sharply from the recent high of 80% in February 2016.2 As spreads have narrowed, the number of distressed issues has fallen, indicating that investors are less concerned about the future prospects of these companies.
The low spread compensation worries us in case we do see a further leg down in oil prices going forward. This is a concern for investors who may own or be interested in investing in individual high-yield energy bonds, but also for the broad high-yield market, as energy issues make up over 13% of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index.3 In the words of S&P, “although commodity pressure has somewhat stabilized, it is clear that underlying risks remain.”4
The death of retail?
Much has been made of the decline in physical retail stores of over the past few years as internet retailers have gained market share, and it’s beginning to affect the high-yield corporate bond market. Defaults in the consumer sector are rising, as is perceived default risk.
While energy and natural resource issues have dominated the default headlines, consumer and service sector issues are beginning to take a greater share of the number of defaults. As the chart below illustrates, energy and natural resource issues dominated the default space in 2016, but the share of defaults from the consumer sector has grown through the first six months of this year, accounting for more than 21% of all defaults.
While energy issues still make up a large part of the default landscape, consumer-focused sectors have been picking up steam this year
Source: Standard and Poor’s, as of 6/30/2017.
This trend could unfortunately be a sign of more trouble ahead. According to S&P, retail and restaurants (part of the consumer/service sector) now have the highest distress ratio, coming in at 21.2%.
The number of downgrades for many retailers has been increasing as well. According to S&P, “about 18% of U.S. retail ratings are in the ‘CCC’ category or lower, about double the level at the beginning of the year.”5 And U.S. retailers have a large negative bias, coming in at 35% at the end of June. A negative bias represents the percentage of companies in a sector with a negative outlook or negative CreditWatch, which indicates at least a one-in-three chance of a downgrade within one year. That compares to a negative bias of 20% for all high-yield issues.6
These risks have pushed credit spreads higher for some consumer sectors, like retailers. The chart below shows that U.S. retailers now offer two full percentage points in yield, on average, more than the broad high-yield market.
The spread between high-yield retailers and the broad high-yield index has widened
Source: Bloomberg, using monthly data as of 7/31/2017. “Retail issues” represents the retail industry of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index.
Although the risk to retailers may not necessarily ripple through the whole high-yield market because they make up only 3% of the broad high-yield index, continued defaults certainly pose a threat to holders of individual high-yield corporate bonds. The unsecured debt of retailers—which is a type of debt more likely to be held by individual investors—tends to have low recovery values in the event of a default, according to S&P, for a couple of reasons. First, most high-yield retailers have a fair share of secured debt, which ranks above the bonds that individual investors are likely to own. That leaves less available for unsecured bond holders. Second, retailers tend to be relatively asset-light, meaning there’s not much value in what’s available for liquidation.
What to do now
Don’t be complacent with your high-yield bond investments. Despite the strong returns so far this year there are areas of the market where risks appear elevated. For those who invest in individual bonds, understand the risks of holding individual bonds in some of these riskier parts of the market. If a given bond has a much higher yield than other bonds with comparable ratings or maturities, it likely has some unique risks that could potentially pull the price lower. If you’re tempted by, but unsure about, a particular high-yield bond, speak with a Schwab Fixed Income Specialist. He or she can help you weigh the risks and rewards of such investments, and help assess whether they make sense for your portfolio.
1 Source: Standard and Poor’s, “Distressed Debt Monitor: Oil And Gas Isn’t In The Clear Yet,” June 26, 2017.
2 Source: Standard and Poor’s, “Distressed Debt Monitor: Oil And Gas And Metals, Mining, And Steel Elevate The Distress Ratio To 2009 Levels,” February 25, 2016.
3 Weight of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index, as of 7/31/2017.
4 Source: Standard and Poor’s, “Distressed Debt Monitor: Oil And Gas Isn’t In The Clear Yet,” June 26, 2017.
5 Source: Standard and Poor’s, “U.S. Retail Debt Recoveries Likely To Be Below Average Amid Sector Challenges And Rising Defaults,” July 13, 2017.