High Yield Bond Fundamentals Improve Despite Record Issue
By Ryan O’Malley, Fixed Income Portfolio Strategist
High yield corporate bond issuance rose 93% in 2021, from $ 106 billion in 2020 to $ 206 billion year-to-date. Investors in corporate bonds generally view these large increases in high yield issuance as negative for credit fundamentals, as they are generally correlated with higher leverage. This cycle can turn out to be very different, however, as the fundamentals of many high yield issuers improve.
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Despite the increase in gross issuance, net issuance of high yield bonds only increased by about $ 38 billion, meaning that 81% of new issuance this year was used to refinance more debt. old. High yield issuers have used the strong demand for spread products to repair their failing balance sheets rather than engaging in mergers and acquisitions or shareholder-friendly activities at the expense of bondholders.
The average coupon of the Bloomberg Barclay’s US Corporate High Yield index fell from 6.24% in February 2020 to 5.86%, while simultaneously increasing the average maturity of these bonds, from 6.06 years to 6 ,53 years. This means that the average high-yielding issuer just reorganized their debt to pay 0.40% less interest while getting an additional six months to pay off the debt, thus lowering their interest charges and increasing their cash flow. available. This is particularly useful for the most vulnerable borrowers, so we’ve seen CCC and “struggling” issuers outperform the YTD by far.
While valuations remain tight, they are not yet quite at the lows of the past 20 years. The BB index still has around 100 basis points of room to tighten before reaching 2005 levels, and CCC spreads are more than 200 basis points higher than their 2007 nadir.
Another point that strengthens the case for high yield bonds in 2021 is the perceived ability of high yield bonds to outperform prime credit in times of rising inflation expectations. Sage examined the relationship between the monthly performance of the High Yield Index and the breakeven 10-year TIPS rate (generally considered a measure of inflation expectations over the next 10 years). We have found that the change in inflation from month to month has a positive covariance with the monthly performance of the High Yield Index of 41% since 1999. In other words, high yield bonds have tend to have a positive performance in months when the breakeven rate on 10-year TIPS increases from the previous month.
In addition to holding high yield bonds, there are a few other strategies that Sage uses to position portfolios to increase inflation; the first is to maintain an overall portfolio duration shorter than that of the relevant benchmarks, and the second is to add to TIPS as appropriate. We prefer the 10-year portion of the TIPS curve over the shorter maturities because we believe the inversion of the yield curve (3-year and 5-year TIPS have higher equilibrium rates than TIPS at 10 years) is unwarranted because inflation is probably longer term proposition. This three-pronged approach should help portfolios outperform if inflation does continue to rise.
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