The yield advantage that high-yield corporate bonds offer relative to U.S. Treasuries has declined sharply over the past year.
We have a neutral outlook on high-yield corporate bonds and think investors should stick with their long-term, strategic allocations. We suggest that no more than 20% of your fixed income allocation be invested in aggressive fixed income investments, which include high yield bonds.
Don’t forget about the risk of low oil prices since energy issues still make up a large part of the high-yield market.
High-yield corporate bond prices have rallied sharply over the past year, driving yields lower. While that’s been a boon for those already invested in high-yield bonds, it means that the entry point is now less attractive than it was for most of last year. And though the risks to the high-yield market appears more balanced today, don’t forget about the potential effects of low oil prices since energy issues continue to make up a large part of the market.
We have a neutral view on the high-yield corporate bond market. Plenty of factors could keep prices supported—still positive economic growth, a declining high-yield default rate, and improving corporate profitability, to name a few.
After hitting a recent peak of 5.1% in December 2016, the trailing 12-month speculative-grade default rate has fallen by a full percentage point in just two months, dropping to 4.1% in March.1 Energy and natural resources issues have been the key culprit, as they were the drivers of the recent rise. Excluding those issues, the default rate was just 1.8% in March, well below the 20-year average of 4.2%.
Corporate profit growth is starting to show signs of life. After sluggish earnings over the past couple of years, the estimated first quarter 2017 earnings growth rate for the S&P 500 is 9.1%, according to Factset. That would mark the highest quarterly growth rate since the fourth quarter of 2011.2
A wildcard for corporations would be expansionary fiscal policies and a potential cut to the corporate tax rate—both would likely help boost corporate revenues and earnings.
Why not more bullish?
So why aren’t we more bullish on high-yield corporate bonds? Valuations matter, and the yields offered today just aren't that high. We think investors should keep their return expectations in check when it comes to high-yield corporate bonds since total returns going forward are unlikely to be as strong as they’ve been in the recent past. In 2016, for example, the total return of the high-yield index was 17.1%, its highest total return since 2009 as prices rebounded from the lows reached during the financial crisis.
The recent strong performance has been driven by a sharp drop in credit spreads. A credit spread, or yield spread, is the difference between a corporate bond’s yield and that of a U.S. Treasury security with a comparable maturity. Since bond prices and yields move in opposite directions, falling spreads generally pushes up the price of bonds. The average option-adjusted spread of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index has dropped to 3.8%, well below the 20-year average of 5.4% and not too far off from the post-crisis low of 3.2% from June 2014. The drop in spreads has led to absolute yields to fall as well—the average yield-to-worst of the index is now just 5.8%.3
High-yield spreads don’t have much room to fall
This chart shows the monthly option-adjusted spread of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index from March 2012 through March 2017.
Source: Bloomberg, using monthly data as of 3/31/2017. 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.
With less room for spreads to fall, there’s less room for prices to rise relative to U.S. Treasuries. For the rest of 2017, we believe that coupon income—rather than price appreciation—will be the key driver of total returns. To put that into perspective, the average coupon rate of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index is 6.5%. Given the lower yields offered today and limited room for price appreciation, we have a neutral outlook on high-yield corporates.
How low oil prices could affect high-yield bonds
Energy issues still make up a significant part of the high-yield corporate bond market. The weight of energy issuers in the Bloomberg Barclays U.S. Corporate High-Yield Bond Index has been rising steadily for the past decade, peaking at 15% at the end of 2016. As domestic issuers ramped up production due to the U.S. shale boom, the amount of bonds outstanding grew. Companies needed to borrow money to expand their facilities and boost their output. While that made sense when oil prices were at or near $100 per barrel, the drop in oil prices means that cash flows have been negatively affected, as issuers have less flexibility to meet their debt service requirements.
Energy issues still make up a large share of the high-yield corporate bond market
Source: Bloomberg Barclays U.S. Corporate High-Yield Bond Index. Columns represent the weight of the energy sector in the index. All columns represent year-end values, except 2017, which is as of 3/31/2017.
Investors appear to have shrugged off the still low oil prices as credit spreads for energy issues have plunged from their 2016 peak—even more so than spreads for the broad market. The average option-adjusted spread of the energy component of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index is now just 4.4%, after peaking at 15.3% just over one year ago, and it is back in line with the sub-5% spreads of 2013 and 2014, before the drop in oil.
It’s true that many domestic oil drillers and producers have become more efficient over the years, so firms are better suited to handle lower oil prices than in years past. According to a study backed by the U.S. Energy Information Administration, drilling and completion costs in 2015 were “25% to 30% below their level in 2012, when costs per well were at their highest point over the past decade.” 4 The study expects a continued downward trajectory in drilling costs going forward.
Despite the improved operational efficiency, investors don’t appear to be compensated enough for taking on the risk of energy high-yield bonds. As the chart below illustrates, the last time energy spreads were this low, oil prices were closer to $90 per barrel. To put that into perspective, today’s relative yields on high-yield energy bonds with oil prices near $50 are close to (or even below) the relative yields offered a few years ago when the price of oil was significantly higher. A further drop in the price of oil could lead to price pressure within that segment of the market.
Energy spreads have dropped sharply
This chart shows monthly OAS data and crude prices from the past five years. Source: Bloomberg and the St. Louis Federal Reserve, using monthly data as of 3/31/2017. 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. WTI Crude Oil is the price for West Texas Intermediate, a grade of crude oil used as a benchmark in oil pricing. Past performance is no guarantee of future results.
What to do now
We think investors should stick with their strategic, long-term allocation to high-yield corporate bonds, and we would wait for modestly higher yields to have a more positive outlook. We suggest investors limit their exposure to aggressive fixed income—which includes high-yield corporate bonds, bank loans, emerging market bonds, preferred securities, and convertibles—to no more than 20% of their fixed income allocation. And keep an eye on the price of oil, since any weakness could lead to high-yield price declines, especially those in the energy sector. Although the price of oil has stabilized, the yields offered on energy bonds may be understating their risks.
1 “The U.S. Speculative-Grade Corporate Default Rate Decreased to 4.1% in March,” Standard and Poor’s, April 3, 2017
2 Factset, Earnings Insight, March 31, 2017
3 Yield to worst is the lower of the yield to worst or yield to call. It's the lowest yield an investor will receive, barring default
4 “Trends in U.S. Oil and Natural Gas Upstream Costs,” U.S. Energy Information Administration, March 23, 2016