The US High Yield Market Paradox – November 2017

Question: Why are US high yield spreads tighter this year when the market has experienced net mutual fund outflows year-to-date?
Answer: Because the US high yield market is shrinking in size.

The current US high yield market presents investors with an interesting paradox. Despite net year-to-date outflows of $6.8 billion from mutual fund investors through October 18, 2017 (source: Lipper), US high yield credit spreads have tightened (please refer to Figure 1 below). Why are US HY spreads tightening in the face of outflows? The answer is that outflows and spreads represent only part of the technical equation. The size of the market has been shrinking steadily for the last year. At its peak in 2016, the US high yield market had approximately $1.36 trillion of par outstanding. As of September 30, 2017, this amount had declined to approximately $1.25 trillion, an  8.1% decline in 15 months,  while  the  default  rate  declined. We  believe  the  shrinking  market  size represents  a  powerful  technical  tailwind  for  the  asset  class  that  easily  overwhelms weekly  technical  mutual  fund  flows,  especially  when  combined  with  the  coupon generated by the asset class. This short note will explore the reasons for the decline in the size of the US high yield market and what it means for US high yield investors.

Fig. 1 – 2017 YTD Flows and Spreads

Source: JP Morgan HY Research for flow data; Spread data from Bloomberg. As of September 30, 2017.

Why is the US High Yield Market Shrinking?

Figure 2 highlights the decline in the size of the US high yield market. It is worth noting that while the US high yield market has declined in size, the US loan market has increased in size.

Fig. 2 – Size of US HY vs. US Loan Market

Source: BofA Merrill Lynch and Credit Suisse, as of August 31, 2017.

Why has the US high yield market shrunk over the past 15 months?

1. Upgrades  Exceed  Downgrades.    Given  solid  corporate  credit  fundamentals,  high yield companies being upgraded to investment grade exceed the number of investment grade companies being downgraded to high yield. In short, more companies are exiting the US high yield universe via credit improvement than are entering it due to weakening fundamentals. This upgrade trend (see Figure 3 ) started in mid-2016 and is prevalent  across  the  entire  high  yield  rating  spectrum,  indicating  that  the  trend  can continue into the foreseeable future.

Fig. 3 – LTM Upgrade to Downgrade Ratio (Par Amount)

Source: JP Morgan High Yield Monitor. As of September 30, 2017.

2. Companies can Finance themselves Outside the US High Yield Market.   We have observed that companies are increasingly raising capital by accessing markets outside of the  US  high  yield  market. For example,  many  US  companies  are  choosing  to  finance themselves in Europe given low absolute rates. Domestic companies, particularly those with European operations, are choosing to take advantage of the rate differential and lock in lower European interest rates and currency advantages, thereby reducing their financing costs.

High   yield   issuers   are   also   increasingly   choosing   to   finance themselves  in  the  US  loan  market. This  strategy  might  seem counter-intuitive  as  short-term  rates  have  been  and  are  likely  to continue  to  move  higher  and  loans  are  floating  rate  instruments. Short term rates are, however, still low from a historic perspective and   issuers   can   choose   to   swap   into   fixed   rates   if   desired. Moreover,  we  have  found  that  many  companies  are  choosing  to finance  themselves  in  the  loan  market  given  the  favourable  pre- payment  terms  of  this  asset  class. Unlike  the  high  yield  bond market where issues are typically not callable for half of their life, loans can be prepaid at any time often with little or no prepayment penalty. Many US high yield companies are currently producing free cash-flow, some of which is being used to pay down debt. Given the lack  of  fiscal  and  tax  policy  clarity  from  the  US  government, company management teams have been reluctant to commit long- term capital to investing in costly capital expenditures or mergers and acquisitions (M&A). Companies are instead using their cash to pay down debt, and loans are attractive precisely because they do not penalize a borrower for repaying debt ahead of schedule.

3.  Primary  Use  of  New  Issue  Proceeds  Remains  Refinancing. Even though the high yield new issue market has been very active since  the  global  financial  crisis,  the  primary  use  of  new  issue proceeds remains the refinancing of existing debt. This means that very  little  new  net  supply  has  come  to  the  market  despite  large gross numbers.

What Does This Mean For Credit Markets?

While US high yield valuations are approaching their cycle tights, we believe this is not only justified, but that spreads can continue to trade  range-bound  or  tighten  for  the  foreseeable  future  for  the following reasons: corporate credit fundamentals remain strong, the default outlook is benign, very few bonds are maturing in the next two  years,  technicals  are  supportive,  and  investors  need  spread product (particularly if rates start to rise). In addition, the US high yield  market  also  generates  approximately  $80  billion  of  annual coupon payments for investors, much of which is reinvested into the asset  class. Against  this  backdrop,  US  high  yield  bonds  can  be viewed as a scarce resource as managers seek to put money to work in a shrinking market where scarcity generates value. It is difficult to predict if the market spread will approach the pre-recession low of  250bps experienced  in June 2006,  but it is equally  difficult to predict  that  high  yield  spreads  will  widen  materially  in  the  near term due to internal factors.

Fig. 4 – US HY (J0A0) Index Historical Spreads

Source: BofA Merrill Lynch US High Yield Cash Pay Index, as of September 30, 2017.

There are still risks to consider. We view the primary risks to the high   yield   market   to   be   rate   risk   and   geopolitical/macro uncertainty. If rates increased suddenly, high yield investors will be better protected compared to their investment grade and Treasury counterparts but the asset class could experience stress similar to the 2013 taper tantrum. The excess spread offered by high yield, however,  should  provide  a  degree  of  cushion  relative  to  higher quality  fixed  income  areas. Geopolitical  risks  also  abound  and a correction  due  to  an  exogenous,  macro  shock  to  the  asset  class could likely lead to a re-pricing of risk assets across the globe. We believe  that  given  solid  fundamentals,  this  type  of  correction represents a buying opportunity and would be similarly short-lived as all the corrections experienced since the 2008 recession.

It is therefore important not to become complacent. We are seeing inflated  asset  prices  globally  and  investors  taking  on  increasingly greater risk for lower returns. We are carefully monitoring whether we  see  significant  deterioration  in  credit  underwriting  standards and/or  an  increase  in  excessive  leverage. So  far,  we  have  not observed this to be the case with the broad US high yield market. We believe, as a firm deeply rooted in fundamental credit research, that  we  are  well  suited  to  protect  investors’  capital  should  we witness  such   a  weakening  of  underwriting   standards. In  the meantime, we believe US high yield represents an attractive spread product and portfolio diversifier for investors.

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