market commentary may 2014-high yield looks expensive

Market Commentary-May 2014

Experience Insight Impact

biegelwaller.com

Overview: There are a number of risks associated with investing in fixed income securities including interest rate risk, credit risk, and liquidity risk. In this presentation, we focus specifically on credit risk. Credit fundamentals have improved dramatically since the depths of the recession, credit spreads are tight, and liquidity flows appear to be healthy. However, the “search for yield” in the low-interest rate environment has inflated valuations, especially in higher-risk/lower-quality credits known as high yield. At the present time, high yield offers unfavorable risk/reward opportunities for investors and caution is warranted.

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Corporate Credit Fundamentals Have Significantly Improved

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• Companies have taken advantage of the interest rate environment to refinance debt at lower interest costs while extending maturities.

• In addition, corporate balance sheets have greatly de-levered over recent years as indicated by the debt-to-equity ratio, meaning credit quality has improved.

• US High Yield default rates of 0.6% are near all time lows and well below the average of 4.0% going back to 1988.

• These positive conditions are already reflected in the market via compressed High Yield credit spreads. A credit spread reflects the additional yield an investor is willing to accept (over a risk-free security such as a US treasury bond) in exchange for taking on risk of a corporate default.


However, There Are Warning Signs We Are Watching

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• Quality of new issuance has been deteriorating with “covenant-lite” (less restrictions placed on the bond issuer) deals becoming more common.

• According to a Wall Street Journal article published on April 3, 2014, covenant-lite loan volume totaled $38.2 billion in 1Q14, which was the second highest YTD total ever recorded.

• These deals allow riskier companies to borrow money on less

restrictive terms by not requiring them to maintain leverage ratios (as an example) within certain predetermined limits.


Yield-To-Worst for the High Yield Sector Reflects Elevated Valuations

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The yield-to-worst (YTW) reflects the lowest potential return that a bondholder can receive without the issuer defaulting. This metric is used to manage risks and understand worst case scenarios. Since 1995, the YTW for High Yield has averaged approximately 9.6%. With the market currently sitting at a YTW of 5.1%, risk/reward appears unfavorable.


High Yield Credit Spreads Are Sitting Near All-Time Lows

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This chart depicts the Barclays US Corporate HY YTW (shown in the previous slide) minus the 10-year government bond yield (referred to as a credit spread). This credit spread is hovering around historical lows, meaning that investors have been willing to accept lower premiums over “risk-free” treasuries in exchange for accepting credit risk. With both absolute yields and relative yield spreads near the low-end of historical ranges, we see a more difficult return environment going forward.

Opinions expressed in this commentary may change as conditions warrant and is for informational purposes only. Information contained herein is not intended to be personal investment advice for any specific person for any particular purpose. We utilize information sources that we believe to be reliable but cannot guarantee the accuracy of those sources. Past performance is no guarantee of future performance; investing involves risk and may result in loss of capital. Consider seeking advice from a professional before implementing any investing strategy.


Disclaimer

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market commentary may 2014-high yield looks expensive

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