By Niklas Nordenfelt and Thomas Price
Fixed income and equity investors alike are keenly aware of the potential for regime change in the interest rate environment. After all, levels of interest rates directly impact discount rates, the costs of financing, consumer behaviour, and business activity—all of which interact to affect the valuation of any investment.
The ultra-easy US Federal Reserve policies of the past several years have, at least in part, achieved their goal of nursing the real economy and capital markets back to health. Alas, they have done so by creating some imbalances that must unwind sooner or later.
High yield fixed income securities and leveraged loans occupy a unique position in capital markets; they span the worlds of fixed income and equities, and therefore respond to risk factors that affect both asset classes. It is interesting to explore the main factors that are influencing valuations in the context of the current interest rate and credit environment. Within this, it can be suggested that a tilt towards higher quality within high yield markets may provide investors with the most attractive expected reward per unit of risk in credit markets today.
The high yield and leveraged loan sectors have relatively higher current yields and shorter maturities in comparison to other broad fixed income sectors. Other things equal, this is desirable in either a rising or steady rate environment. Moreover, there is a well-documented negative correlation between Treasury yields and credit spreads; when Treasury rates rise, spreads tend to tighten, muting some of the immediate impact of Treasury volatility on the high yield sector. However, the high yields offered by these instruments are not a free lunch; they are a spread premium received for assuming higher levels of credit and liquidity risk not found in other debt instruments.
Credit spread premiums are determined by a bond’s or loan’s priority in the capital structure and the underlying strength of business conditions (which in turn are driven by both company-specific and macro-economic factors). Deteriorating business conditions, for example, can simultaneously threaten both the earnings outlook and the ability to make debt payments of a weaker high yield issuer. Thus, it is clear that all of the factors that affect equity valuation also affect the valuation of credit, and systemic factors will simultaneously drive both broad equity and credit market valuations.
From here it is intuitive that equity volatility, which until recently has been subdued, has historically demonstrated a direct relationship to spread volatility. High yield spreads have increased significantly from the post-financial crisis lows in 2014, and are now wider than their multi-decade average. If seen as a continuing trend, this would be cause for concern. However, this was a reaction to a weakening global growth environment rather than concerns over deteriorating fundamentals across the majority of high yield issuers (i.e. issuers outside of the energy and metals/mining sectors).
Reasons for this include that, firstly, labour market conditions remain supportive, and secondly that US GDP growth appears to be weathering global economic weakness. Spreads have widened dramatically in specific commodity and energy related sectors, which are deeply exposed to weaker demand from China and other emerging markets as well as declines in energy prices. However, the economic impact to the vast majority of issuers within high yield is muted and arguably positive for many. Those issuers now offer more compelling risk/reward characteristics as a result of the recent, broad-based selling pressure driven by concerns surrounding the commodity and energy sectors.
Broadly speaking, coverage levels and balance sheets remain strong and can accommodate some softening in top-line growth.
Furthermore, unlike other asset classes, high yield has a far larger percentage of its issuers exposed primarily to the US economy. Default risk is increasing, but is still below average, excluding commodity-based industries, in what is a very accommodative environment and one which is likely to remain accommodative even after initial rate hikes.
Nevertheless, it is important for investors to take note of some distortions that have been exacerbated by easy monetary policies, as these may disproportionately affect lower quality issues. There is little doubt that monetary conditions have lengthened the credit cycle. The credit window has been open for an extended period, even to the riskiest borrowers, and companies are racing to lock in long-term financing. Due to this, some of the late-cycle structures are concerning in lower quality segments.
We believe that higher quality segments offer a natural, and low cost hedge against possible outcomes that could be painful for the lower quality segments.
Overall, a prudent course in risk management suggests that high yield investors can achieve a favourable expected return per unit of risk by tilting toward higher quality segments of high-yield markets. Investors can also benefit from experienced, well-resourced active managers that can overcome some of the systemic risks discussed through diligent fundamental research and careful credit selection.
Niklas Nordenfelt is senior portfolio manager for the Wells Fargo US High Yield Bond fund and Thomas Price is senior portfolio manager for the Wells Fargo US Short-Term High Yield Bond fund.
