It’s all relative
"All you need is the plan, the road map, and the courage to press on to your destination"
- Earl Nightingale
Despite the fastest spread-widening in high yield bond history (13 trading days since February 19th) and the largest one day widening on March 9th, as an asset class high yield bonds has still held up quite well relative to US equities. Since the most recent market peak on February 19th, the S&P 500 is down nearly 19% (to market close on March 9), while high yield is down close to 7% as measured by the ICE BofA US High Yield Constrained Index. Since its inception in the late 1980’s, high yield as an asset class has experienced approximately 50% of the downside of US equities.
I doubt anyone could have predicted Saudi Arabia’s response to Russia’s decision to not agree to additional oil production cuts. The Saudis in turn have decided to increase production and cut the price on their exports to various degrees around the world creating an all-out price war. Russia in turn has also decided to open the spigots. The result of these decisions has been a massive shock to both equity and fixed income markets as oil, measured by West Texas Intermediate price per barrel, fell by 25% on Monday March 9th.
There is no denying that the fall in energy prices will be felt by the overall high yield market. JP Morgan’s base case on defaults assumes crude oil returns to US$40/bbl in 2H20 and rises to US$50/bbl in 2021-22. Under that scenario they assume cumulative sector defaults approach 24%. Their analysts believe the bulk of defaults in that scenario would occur in 2021 and would be concentrated in offshore oil services and exploration and production sectors. However, we need to keep this in context with the broader market, as the energy sector only represents 11% of total high yield issues. There will likely be some contagion to other sectors given the current credit environment; higher levels of leverage, and further risk due to COVID-19, but we do not believe it is time to indiscriminately avoid high yield.
Given the record low levels of US Treasury yields and low yield of investment grade bonds, high yield provides an attractive relative yield for income-seeking investors. On a relative basis high yield bonds offer three times the yield of investment grade bonds, and fourteen times the yield of 5-year treasuries. While some of the enhanced yield comes from CCC-rated bonds, BB’s and B’s still yield 5.3% and 7.8%, respectively.
Dennis McCafferty, portfolio manager of the Manulife Global Unconstrained Bond Fund, comments “With lower government yields and ~US$15 trillion of negative-yielding debt globally, market participants should be increasingly interested in High Yield bonds with ~7% yield. The recent volatility affected all sectors and we are finding many attractive opportunities. The trajectory of COVID-19 is still highly uncertain so we’re deploying cash gradually.”
Over the last year, the Capital Markets Strategy team hasfavoured a more of a defensive posture by allocating to high yield as an equity proxy with better downside protection. This has played out well, especially considering recent events. We continue to favour this asset class for its relative downside protection and upside optionality on any potential recovery. It also remains attractive from an income perspective compared to other asset classes.
The key, however, remains an active approach and an understanding of the relative opportunity that exists.
Kevin Headland, CIM
Senior Investment Strategist
Important disclosures
A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.
Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.
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