The High Yield Bond Market: 2016 Review, 2017 Outlook
By Heather Rupp, CFA, Director of Communications and Research Analyst for Peritus Asset Management, Sub-Advisor of the AdvisorShares Peritus High Yield ETF (NYSE Arca: HYLD)
We entered 2016 coming off a tough year for the high yield market. The free fall in energy and other commodity prices over the course of 2015 not only caused a collapse in bonds in the energy and commodity sectors, but the pricing declines spread to the entire high yield market, as these two sectors together made up over 20% of the index going into that year, with energy alone about 18% of the index.1 Spreads and yields on the high yield market had widened from 373 bps and 4.9%, respectively, in mid-2014, prior to the energy rout, all the way to 706 bps and 8.7%, respectively, to close out 2015.2 We reached high of 897 bps on the spread and 10.1% on the yield-to-worst in mid-February 2016.3, and then saw a rebound in high yield as energy prices stabilized and market participants found value in the broader high yield market. We closed out 2016 with a strong return of 17.1%.4
As we entered 2016, we believed the high yield bond market was hugely undervalued (see our writings “The High Yield Market Repricing: An Opportunity” and “A Negative 2015, but an Opportunity Ahead”), and investors who stepped in reaped the rewards over the year. But often the concern after a very strong year of returns becomes, is there room for the market the run further? While we don’t anticipate returns as high as we saw in 2016 in the coming year, we do believe that the high yield market remains positioned to generate attractive returns in 2017.
First, we need to keep this 2016 return in context: again, it was coming off a very negative 2015 and bond prices/spreads were at levels not seen since the financial crisis. Looking at the return over the last two years, together those years returned 11.9%, or 5.8% per year on an annualized basis.5 As a point of context, looking at the returns for the high yield bond market over the last 30 years, the annualized return over this period is 8.3%6. Thus, what we have seen over the last two years certainly isn’t high by any historical standard. So yes, we saw a big more last year but that was due to the dramatically undervalued market and pricing going into 2016.
As we sit today, we can’t make the call that a huge portion of the high yield market is undervalued as we could a year ago. Instead, with the run we had in 2016, this is now a much more normalized market, as we see some of the market as overvalued, along with some securities that are fairly and undervalued. The index ended the year with an average price of $99.80, which to put in some perspective is down from the average price of $105.77 a year and a half ago, right before the decline in the high yield market began.7 At that time (June 2014), the average spread on the market was 373 bps and the yield 4.9%, versus the average spread of 442 bps and yield of 6.1% at the end of 2016.8 So some spread compression, in addition to the average coupon on the high yield bond index of 6.5%, doesn’t seem out of the question.9 Interestingly, the yield on the 10-year Treasury was just about the same back in June 2014 compared to YE 2016.10 On the risk side, default rates are expected to be well below historical averages this year (see our recent writing, “High Yield Default Rate: 2016 Return and 2017 Outlook”).
Spreads have compressed over the last year and prices for many bonds are now at premiums. In some cases, yields are so low we don’t see the investors are getting properly paid for the risk. Yet, there are still what we see as attractive investment opportunities for active managers who can look for value. There are still bonds that offer what we see as compelling yield given the risks of the security and while the capital gains opportunities are not as widespread as they were a year ago, there are still discounts available. Even a few points of price appreciation along with a steady coupon income can bring with it a very attractive total return for an investment. The goal of active management is to provide performance superior to that offered by an index and we feel that today’s high yield market offers that opportunity for active high yield investors; in fact, we believe active management will matter much more in 2017 than it did in 2016.
1 Approximate sector market weights as of the end of 2014. Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. A90, A91
2 Index referenced is the Bloomberg Barclays US High Yield Index, which covers the universe of fixed rate, non-investment grade debt. Data sourced from Barclays Capital, as of 6/30/14 and 12/31/15. Yield referenced is the yield-to-worst and spread referenced is the spread-to-worst. Yield-to-worst is the lowest, or worst, yield of the yield to various call dates or maturity date.
3 Index referenced is the Bloomberg Barclays US High Yield Index, which covers the universe of fixed rate, non-investment grade debt. Data sourced from Barclays Capital, as of 2/11/16, the high in spreads and yields. Yield referenced is the yield-to-worst and spread referenced is the spread-to-worst.
4 Annual performance of the Bloomberg Barclays High Yield Index for the period 1/1/1987 to 12/31/2016.
5 Cumulative and annualized performance of the Bloomberg Barclays High Yield Index for the period 1/1/2015 to 12/31/2016.
6 Annualized performance for the Bloomberg Barclays High Yield Index for the period 1/1/87 to 12/31/16. Data sourced from Barclays Capital.
7 Average price for the Bloomberg Barclays High Yield Index as of 12/31/16 and 6/30/14. Data sourced from Barclays Capital.
8 Spread-to-worst and yield-to-worst for the Bloomberg Barclays High Yield Index as of 12/31/16 and 6/30/16. Data sourced from Barclays Capital.
9 Average coupon for the Bloomberg Barclays High Yield Index as of 12/31/16 and 6/30/14. Data sourced from Barclays Capital.
10 Yield on 10-year Treasury was 2.53% on 6/30/14 and 2.45% on 12/31/16. Data sourced from the US Department of Treasury.