by Fixed-income investors face a difficult dilemma these days. By definition, they seek yield to meet their investment goals, but many financial market observers are predicting trouble in one popular source of such yield – the high-yield bond market. There’s real cause for concern. The junk bond market has seized up several times in the past few years, undergoing sharp, sudden swings due to periodic lacks of liquidity. As the Federal Reserve’s long-anticipated December rate hike began to approach and oil prices sank below a barrel, the liquidity problem became so acute that at least three high-yield funds were forced to liquidate. Yields on U.S. high yield bonds shot up from 7.43 percent in early November to 8.89 percent as of December 18. Energy makes up 11 percent of the U.S. high-yield bond market (as measured by Barclays US high yield bond index) and falling oil prices are a particularly serious source of concern to investors regarding the ability of issuance companies to service their debt. The price of West Texas Intermediate oil fell from more than a barrel in June to a low of .59 in mid-December. In the week that ended December 18, investors pulled a net .8 billion out of high-yield bond funds, the largest withdrawal since a record-breaking .1 billion outflow in August 2014.
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Ashley Kindergan considers the following as important: Credit Suisse, fixed income, high-yield bonds, Investing: Features, leveraged loans, senior loans
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Fixed-income investors face a difficult dilemma these days. By definition, they seek yield to meet their investment goals, but many financial market observers are predicting trouble in one popular source of such yield – the high-yield bond market. There’s real cause for concern. The junk bond market has seized up several times in the past few years, undergoing sharp, sudden swings due to periodic lacks of liquidity. As the Federal Reserve’s long-anticipated December rate hike began to approach and oil prices sank below $35 a barrel, the liquidity problem became so acute that at least three high-yield funds were forced to liquidate. Yields on U.S. high yield bonds shot up from 7.43 percent in early November to 8.89 percent as of December 18.
Energy makes up 11 percent of the U.S. high-yield bond market (as measured by Barclays US high yield bond index) and falling oil prices are a particularly serious source of concern to investors regarding the ability of issuance companies to service their debt. The price of West Texas Intermediate oil fell from more than $60 a barrel in June to a low of $34.59 in mid-December. In the week that ended December 18, investors pulled a net $3.8 billion out of high-yield bond funds, the largest withdrawal since a record-breaking $7.1 billion outflow in August 2014.
Low interest rates and strong investor demand for high-yielding instruments during the Fed’s zero interest rate policy period has encouraged massive new issuance of high-yield bonds with increasingly high credit risks over the past few years. The distress ratio, or the proportion of credits trading at a 10 percent spread to Treasuries, has increased significantly, and Credit Suisse’s Investment Solutions and Products team expects default rates to rise from 2.98 percent to 4.4 percent by the end of 2016. If commodity prices continue to decline, however, that number could rise as high as 5.7 percent. Were that to happen, Credit Suisse says investors can expect a second wave of defaults in 2017 as the business cycle troughs, an outcome that would put pressure on both banks and overall consumer sentiment. When higher default rates are predicted, it’s important for investors to know that the recovery rate – the proportion of principal and accrued interest that U.S. high yield bondholders receive in the event of a default – is 29 percent, an unusually low figure. Given the expected default rate of 4.4 percent and prices of 88%, high-yield bond investors’ expected losses in the event of a default is about 2.5 percent. That’s something investors would be wise to consider when tempted by the rising yields in the junk market.
Funds that invest in senior loans, sometimes known as leveraged loans, haven’t had it much better, having experienced 13 straight months of outflows. Yields on leveraged loans have risen from 6.56 percent at the beginning of November to 7.2 percent – lower than high-yield, given some added protections for investors, but still not immune to losses in the face of rising interest rates. Both high-yield bonds and leveraged loans have produced negative total returns so far in 2015, –5.5 percent and -0.65 percent, respectively.
Though liquidity risks will remain a major concern for both bonds and loans as markets adjust to the Fed’s first rate hike in nine-and-a-half years, senior loans do offer some protections to investors that high-yield bonds do not, making up for their lower yields. Leveraged loans are syndicated, floating-rate bank loans made to companies with credit ratings below investment grade. Unlike high-yield bonds, the credits are secured with a company’s assets, with investors among the first in line to get their money back if the firm defaults on its debt. The leveraged loan market is also less exposed to the energy market than high-yield bonds.
The 12-month trailing default rate on senior loans is 1.67 percent, well below the historical 15-year average of 3.2 percent and lower than the trailing 12-month default rate of 3.96 percent for high-yield bonds. Investment risks and market uncertainty can increase when a large number of loans come up for refinancing at the same time, but 70 percent of outstanding loans come due in 2020 or later, making the so-called “maturity wall” a medium-term risk rather than an imminent one.
Floating interest rates can offer senior loan investors more protection in a rising-rate environment, though that’s not necessarily the case today. Most senior loans pay a base rate tied to either the 30-day or 60-day LIBOR, an interbank lending rate, plus a fixed spread. However, many loans also come with a clause that interest rates will not float until LIBOR rises above 1 percent. Since 30- and 60-day LIBOR were 0.413 percent and 0.497 percent, respectively, as of December 18, it will be some time yet before investors start to reap the benefits of those floating rates. Still, Credit Suisse believes that the Federal Reserve is on the track of hiking interest rates by a total of 1 percentage point by the end of 2016, which means that senior loans could break through their LIBOR floors in the coming months. Though Credit Suisse notes that loans may face greater liquidity risks than high-yield bonds because they trade less frequently, demand for leveraged loans tends to increase during Fed tightening cycles due to their variable-rate coupons.
While leveraged loans carry lower risks than high-yield bonds, they certainly aren’t risk-free. The low interest-rate environment of the past seven years has lured many investors further out on the yield curve, and many loans issued in recent years come with higher leverage, weaker covenants (financial requirements that issuers must meet or suffer financial penalties), and lower seniority, meaning that lenders’ claims are further back in the company’s line of creditors in the event of a default.
Credit Suisse stresses that in this environment, it’s important for investors and bondholders to review the individual financial conditions of high-yield bond and leveraged loan issuers – both when they are buying and when they are thinking of pruning their holdings. While high-yield funds are likely to experience further outflows, particularly since retail investors now make up a larger share of bondholders than in the past, the market may also see temporary rallies. Investors may want to use these pockets of liquidity to selectively shed high-yield assets, but otherwise, Credit Suisse thinks that those investors who can withstand mark-to-market losses should refrain from indiscriminately dumping high-yield bond holdings. With liquidity scarce, selling high-yield products may be unacceptably costly in the current volatile environment. Given their relatively lower risks, leveraged loans may be a better choice than high-yield bonds for investors looking to pick up some carry, but Credit Suisse maintains a very cautious outlook on the whole world of high-yielding fixed-income products heading into 2016.