Is high yield fixed income still attractively priced?
Editorial Note: This post originally appeared on our companion blog, Fiduciary Matters, on March 9, 2016.
An opportune time for high yield?
The market volatility of early 2016 makes this an interesting time for opportunistically-minded investors. One sector attracting attention is high-yield fixed income1. High yield saw a big sell-off in January and February of this year and sharp rebounds in the last three weeks. The fixed income team here at Russell Investments has been tracking its fortunes closely. The U.S. Treasuries Option Adjusted Spread (OAS) spread was 839 basis points on February 11 this year. As of Friday, March 10, the spread tightened to 665 basis points, which was similar level as the end of 2015. Despite the yield spread rising and falling this year, the team continues to see value in the high yield sector, albeit with the likelihood of ongoing volatility.
Their analysis starts with the state of the economy (“cycle”.) On its own, this doesn’t paint a positive picture. As Yoshie Phillips, a Senior Research Analyst in that team, puts it “We have entered into a commodity-led default cycle and have seen signs of declining credit fundamentals. But the financial matrix for companies outside of commodity sectors are still by and large reasonably healthy. Our strategists also don’t think U.S. recession is a near-term risk, at least in 2016.”
The appeal of high yield fixed income lies, rather, in the pricing (“value”.) TThe yield spread over higher-quality debt remains still reasonably attractive for certain industries and credits, despite having moved off of its high, and the level of default that is priced in to the market is higher than the team’s expectations. Yoshie also points to the significant dispersion that exists between some companies and sectors where active managers can pick their spots – most notably the bifurcation that exists between the stressed commodity-related sectors and the rest of the market.
The third leg of the team’s analysis is to overlay a sense of the state of the market (“sentiment”.) Yoshie points out that, in the late part of the credit cycle, investor sentiment can be volatile and quickly amplify market movements, both positive and negative: “With the broker dealers not providing liquidity anymore2, the market has been very reactive to mutual fund flows and that has contributed to massive spread dispersion.” She notes that, in her view, over 8% yield (return) is typically the level that has drawn capital into this asset class in the past, especially in the context of muted recession concerns concerns and the low level of interest rates around the globe.
Getting the timing right
Just because the valuation is attractive doesn’t make this the right move for everyone: risk tolerances need to be considered. And timing, too, is (as always) a difficult call. So while the team sees the cycle-value-sentiment structure as pointing to a modest overweight for high yield, this is a situation where dollar cost averaging—legging in with a series of small moves rather than a single big jump—has some appeal.
1 A high-yield bond is a high paying bond with a lower credit rating than investment-grade corporate bonds, Treasury bonds and municipal bonds. Because of the higher risk of default, these bonds pay a higher yield than investment grade bonds.
2 According to the Federal Reserve Board on October 5, 2015, broker inventory has declined by more than two-thirds from December 2007 to December 2014.