US high yield bond segment could face some pressure

WHILE most other major fixed income segments are posting losses on a year-to-date basis, the US high yield bond space has managed to thus far retain its year-to-date gains of 1.6 per cent (in US dollar terms). While this may seem paltry in absolute terms, it represents a sizeable outperformance over/against other fixed income segments.

Over the past three years, US high yield has been one of the strongest-performing segments of fixed income, following the plunge in oil prices between late 2014 to early 2016 which caused carnage in the shale gas industry, and in turn sparked a blow-out in spreads (risk premium) for US high yield. This blow-out in spreads set the base for the next three years of strong returns. US high yield delivered a very handsome cumulative return of 28 per cent from the beginning of 2016 to Oct 22, 2018 in US dollar terms.

The outperformance of the US high yield segment thus far in 2018 has come on the back of tightening credit spreads, driven in part by rising risk free rates as well as a domestic economy that continues to be driven by supercharged fiscal stimulus.

However, its outperformance in recent years resulted in reduced attractiveness for those seeking to gain exposure to the segment today.

With an unfavourable combination of a rising risk-free rate and lower yields, credit spreads on US high yield bonds as measured by the Bloomberg Barclays US Corporate High Yield Index have narrowed to 344 bps (as at Oct 22, 2018), near some of the lowest levels on record and a significant distance from the 560 bps average spread since October 2000. With the spread representing a premium for taking on credit risk, a narrowing of credit spreads signals that valuations in the US high yield bond sector have become more expensive.

In addition, the increasing acceptance of weaker covenants in new issuance suggests that investors have become less discerning in seeking appropriate high yield securities, while the leveraged loan market (an alternative financing means for non-investment grade companies) has also seen a boom in "covenant-lite" issuance - over US$440 billion in 2018 thus far compared to US$498 billion in 2017 and US$345 billion in 2015. Issuers have been able to get away with better pricing amid hot demand for loans by offering lower covenants and yields to the detriment of investors.

The allure of US high yield bonds has been evident thus far in 2018. This is despite a rising risk-free rate which has caused bond yields to rise (and bond prices to fall) in almost every other segment over the course of the year.

The underlying reason for the high yield segment's resilience is that high yield bonds historically fare well during periods of strong economic growth, as investors are primarily concerned with default risk. Defaults are less likely to occur in a strong economy. Moody's forecasted a 2.5 per cent default rate for US high yield bonds for 2018, falling to 2.1 per cent in August 2019. This is on the lower end of the historical range, and significantly below the historical average of close to 5 per cent since 1983. Given the expectations that the US economy would to continue to grow, yields in the segment are unlikely to rise quickly from current levels, although the low spread signals a lack of value as investors are now not as well compensated for default risk.

While we expect the US economy to grow, we are wary of fundamental tailwinds and fiscal boosts that are fading; a growing list of potential global issues; and margin pressures stemming from higher interest rates and labour costs beginning to surface. Given the above, the US high yield bond space could face some pressure down the road.

While investors who are already vested in the segment might wish to review their holdings, those who are looking to gain exposure to this fixed income segment at this juncture may be better served looking for opportunities in other fixed income segments that are on sale.

Over the past few months, the Asian high yield and hard currency emerging market debt segments have been highlighted in this monthly column as fixed income segments that are currently on sale.

The good news is they still offer investors value in terms of yield and a fairer risk-premium as compared to US high yield.

In the Asian high yield space, funds such as the Allianz Dynamic Asian High Yield Bond Fund, Eastspring Investments - Asian High Yield Bond Fund and the Fidelity Funds - Asian High Yield Fund are options for investors to consider.

As for the emerging market debt segment, the likes of the Neuberger Berman Emerging Market Debt Hard Currency Fund, Pimco Emerging Markets Bond Fund and the Amundi Fund Global Emerging Hard Currency Fund are some of the products that focus on the sovereign hard currency space with strong track records and teams in place.