HY EXPLODED HIGHER WITH CENTRAL BANK REVERSAL: NEARING STRONG OVERHEAD RESISTANCE



A PUBLIC SOURCED ARTICLE FOR MATASII (SUBSCRIBERS-SII & PUBLIC ACCESS) READERS  REFERENCE

SII - BONDS & CREDIT

MATASII SYNTHESIS:

  • "JNK" is now testing an overhead resistance trend-line (upper black dotted line below),
  • There is still an unfilled Gap above this level.
  • Likely retest of 100 DMA (blue line) before possibly advancing higher.

We think it's fairly safe to call what is happening in corporate debt a late-cycle phenomenon.

  • High corporate leverage,
  • Loose covenant protections,
  • Tightening loan standards and
  • Weakening earnings are all pointing in one direction.

Up to this point increasing leverage has in our minds not been so threatening as it has been matched with excellent interest coverage.

However, now that the interest rates have risen appreciably from their lows, this argument breaks down somewhat. The real question is "has the tightening cycle gone far enough to engineer broad stress in the sector?"

While we would love to pound the table and say that the rise in short-rates due to Fed tightening will in quick order lead to weakening interest rate coverage, the truth is that interest rate rises take a long time to filter to borrower interest costs as companies take their time to refinance into higher coupon debt.

The more likely culprit of high-yield distress will likely be a recession which will ultimately drive defaults.

 



Some detailed reading to support the above MATASII Chart:

SOURCE: High-Yield CEF Sector Update: Defying Gravity, But For How Long?

The high-yield sector has rallied sharply from its December sell-off on the back of lower interest rates and tighter credit spreads.

Corporate debt as percentage of GDP stands at a record high, and higher interest rates should worsen interest coverage metrics in due course; however, the sector party still continues.

In the sector, we like EAD, KIO and IVH as funds having good yield, decent valuations, and strong alpha.

Well, that was quick. There was barely time to say "oh my" when the high yield sector bounced right back from its December sell-off. The long-expected corporate cataclysm over ever-higher leverage amid a slowing economy has been put on hold, at least for the time being. Risk appetite has returned, and the sector has benefited from both a tightening in credit spreads as well as a drop in rates.

Source: ADS Analytics LLC, Bloomberg

We are fairly cautious on the sector given worsening valuations (lower nominal rates and tighter credit spreads) as well as fundamentals (ever higher leverage and worsening interest coverage); however, we do not advocate full abstinence.

To gauge the more attractive funds in the sector, we apply our usual sector screen, which is composed of three different metric types: valuation, yield and alpha. Valuation we proxy by absolute and relative discount, yield stands for the past 12-month distribution rate, and alpha we estimate by excess annual return versus the sector over the last five years.

More specifically, we use the following parameters in our screen:

  • 12M Yield > 8%
  • Discount < -7%
  • Discount percentile < 75% (fund's discount is below the top quarter in its history)
  • 5Y annual Average Excess Return > 0.75% (fund outperformed sector by 0.75% per annum over the last five years)

Source: ADS Analytics LLC, Bloomberg

Applying the screen above, we get the following funds:

  • Wells Fargo Income Opportunities Fund (EAD)
  • KKR Income Opportunities Fund (KIO)
  • Ivy High Income Opportunities Fund (IVH)

We think these funds show a good balance of value, yield and alpha.

Big Picture View

In this section, we take a quick look at how the sector fits into the rest of the closed-end fund space.

Over the long-term, the high yield sector has put up pretty good returns - it is the third best-performing sector since 2004 - although since 2010 (in the chart below), it has not been as impressive.

Source: ADS Analytics LLC, Bloomberg

Interestingly, out of the rest of fixed-income sectors, the high-yield sector has generally come out on top. In our view, this has to do with the fact that the sector has collected two historically attractive risk premia: duration and credit risk both which have rewarded investors. Where do these risk premia stand now?

The duration risk premium is much less rewarding currently given the term premium is negative.

Source: ADS Analytics LLC, Bloomberg

Credit spreads are well off the historic lows, but nowhere near the peaks and below the average since 2010.

Source: ADS Analytics LLC, Bloomberg

This suggests to us that forward returns in the sector are unlikely to be as high as they have been historically.

As far as yield and AUM, the sector is stuck in the middle of both characteristics with about half the CEF sectors we follow sporting higher yields. Part of this is due to a few shorter-duration target-term funds which drag the AUM-weighted yield lower than is actually available in other funds in the sector.

Source: ADS Analytics LLC, Bloomberg

Sector Month In Review

January returns erased what was a miserable previous four-month period for the sector caused by deteriorating sentiment and hawkish Fed comments with February adding further fuel to the rally.

Source: ADS Analytics LLC, Bloomberg

Zooming out a bit to annual returns, the sector has returned to positive annual returns after a 10% drop in 2018 - the biggest fall since 2010 and only the second down year since then.

Source: ADS Analytics LLC, Bloomberg

Monthly fund returns ranged widely and spanned over 10% with all funds finishing in the green.

Source: ADS Analytics LLC, Bloomberg

Valuation View

If we compare the sector yield to the rest of the income sectors, the picture is not overly appealing. Historically, the high-yield sector yield has traded well above the average of the other sectors; however, it has now converged and does not offer a premium.

Source: ADS Analytics LLC, Bloomberg

Another chart we like is the yield percentile (which measures where the sector yield is relative to its history) vs. sector Z-score. The sector yield percentile is among the lowest, suggesting the high-yield sector yield has rarely been lower. The sector Z-score is negative, which is well and good, but not especially so.

Source: ADS Analytics LLC, Bloomberg

The picture that emerges from these metrics is that of a sector that is not overly appealing relative to the rest of the income space.

Fundamental View

Our favorite single indicator of medium-term health of the corporate sector is the loan standards figure - a point we made in our recent Weekly. This metric tends to lead corporate defaults by a few quarters and has recently spiked after several years of benign readings as loan officers tightened standards after several years of loosening.

Source: ADS Analytics LLC, FRED

Taking a broader view, we think it's fairly safe to call what is happening in corporate debt a late-cycle phenomenon. High corporate leverage, loose covenant protections, tightening loan standards and weakening earnings are all pointing in one direction. Up to this point increasing leverage has in our minds not been so threatening as it has been matched with excellent interest coverage. However, now that the interest rates have risen appreciably from their lows, this argument breaks down somewhat. The real question is "has the tightening cycle gone far enough to engineer broad stress in the sector?"

While we would love to pound the table and say that the rise in short-rates due to Fed tightening will in quick order lead to weakening interest rate coverage, the truth is that interest rate rises take a long time to filter to borrower interest costs as companies take their time to refinance into higher coupon debt. The more likely culprit of high-yield distress will likely be a recession which will ultimately drive defaults.

Analysts at Moody's are drawing particular attention to record corporate leverage and particularly the divergence between it and corporate default rate.

Previous record highs for the ratio of corporate debt to GDP (hereafter I will refer to nonfinancial corporate debt as corporate debt) were attained in 2009's second quarter, 2001's final quarter, and 1990's final quarter. Each previous cycle peak for the ratio of corporate debt to GDP either coincided with or was quickly followed by cycle highs for the U.S. high-yield default rate's calendar-quarter average of 14.5% in 2009's final quarter, 10.9% in 2002's first quarter, and 12.2% in 1991's second quarter.

Source: Moody's

The somewhat unsatisfactory explanation they reach for the divergence is that healthy pre-tax profits and decent systematic liquidity explains the sector's strong performance. However, we think tightening financial conditions and disappointing earnings will eventually stress this explanation. So far, the sharpness of the relief rally from the December drawdown suggests that this is still not at the forefront of market's attention.

The four sector drawdowns since the financial crisis have all been relatively short-lived as the sector clawed back the losses fairly quickly. The chart showing historic credit spreads below illustrates this point well.

Source: ADS Analytics LLC, Bloomberg

Elsewhere, AllianceBernstein expands on this point and looks at sector drawdowns in the past 20 years, commenting:

The US high-yield market has suffered ten peak-to-trough losses greater than 5% in the last 20 years. On average, investors recovered their losses in only four months -and sometimes as few as two. Following the longest and largest drawdown of -35%, which lasted 19 months, investors who stayed in the high-yield market earned back 55% in just eight months.

Source: AllianceBernstein

Conclusion

Over the last decade or so, the high-yield sector has put up pretty impressive returns, outperforming the rest of the fixed-income space and even rivaling some equity-linked sectors. This strong performance has been driven largely by well-rewarded duration and credit risk premia which are now much less attractive, and for this reason, we would not expect the sector strong outperformance to continue. Furthermore, the sharp increase in corporate leverage has not been matched by either a rise in defaults or credit spreads. Even a rise in interest rates has not yet fed into higher borrower debt servicing costs. So, for the time being, the party in the sector continues and the recent rally suggests that investors are still dancing. Ultimately, we may have to wait for a recession to finally put an end to this party.

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In the coming weeks, we plan to launch Systematic Income - our Marketplace service on this platform. In addition to detailed analytics of CEF funds and sectors, frequent tactical screens and ideas, we plan to publish and discuss regular updates and performance of our target-yield portfolios. We hope you can join us.