Another year has passed and as we look to the scoreboard it’s clear it was a good
year for risk assets. One need not look further than the double digit returns earned
by domestic and international stocks (in the U.S., the S&P 500 gained +22% while
the NASDAQ returned +30%), as well as the universal collapse in volatility (fear)
across sectors. The year marked decade lows in implied (VIX) and realized equity
volatility and very tight trading ranges for corporate credit spreads. As for high yield
bonds, though returns were dwarfed by the +17% gain realized in 2016, the asset
class returned a solid +7.5% this year, as ~6pts of carry was enriched by low default
volumes and declining risk premiums.
As we think prospectively about the broader investment landscape, with December
and 2017 in the rearview mirror, Buffet’s adage comes to mind – be fearful when others
are greedy [and greedy when others are fearful]. Sure, the most egregious example is
the crypto-currency mania (almost comically consistent with late-cycle behavior on a
grand scale). A slight variant of the Buffett maxim feels appropriate for the high yield
market – be cautious when others are complacent. The average risk premium in the high
yield market now sits below +320bps (the absolute tights of this cycle), with over 40%
of the market priced inside of +250bps (also a post-crisis extreme). While absolute
spreads appear compressed in a historical sense, this alone does not preclude further
tightening. The current risk/reward on offer in the marketplace leaves us uninspired
when contextualized by the fundamentals – high corporate leverage, structural
challenges facing an increasing number of industries, lackadaisical underwriting
standards, macroeconomic uncertainty, and elusive market liquidity, to name a few.
As a result, we enter 2018 steadfast in our conservative bias, with our core holdings
concentrated in credits with durable balance sheets, non-cyclical business drivers and
high free cash flow generation. In this way, we preserve ample capacity to add risk
aggressively when valuations improve.
High Yield OAS is in the Bottom Quintile of Historical Levels, Though not Quite at the Tights of the Prior Cyclical Peaks…
(Barclays U.S. HY OAS)
Source: Bloomberg, TCW
…However, Relative to Fundamentals, we are at 2007 Extremes
(HY OAS per Unit of Leverage)
Source: Credit Suisse, Morgan Stanley Research, Citigroup Index, Bloomberg
Market Performance
Despite a volatile fourth quarter the high yield market hobbled into year-end capping off a very respectable year, at least in terms of performance (see chart below). High yield bonds returned +0.3% for the month, as ~50bps in monthly coupon counterbalanced the headwinds from negative technicals (sizeable year-end primary volumes and retail outflows from ETFs) and large intra-month moves in interest rates.
Source: Barclays
While we continued to see sector and credit specific catalysts drive relative performance in the marketplace (more details below), factors more systemic in nature, such as poor market technicals and interest rate volatility, exerted notable pressure this month. Indeed, high quality credits were the clear underperformers as greater empirical durations were amplified in this low absolute spread environment (BB-rated credits yielding ~200bps over Treasuries offer de minimis cushion to absorb volatility in interest rates). BBs returned just +10bps vs. higher beta Single-B and CCC cohorts at +34bps and +79bps, respectively. Moreover, large, liquid capital structures felt the pressure from ETF and portfolio manager selling to fund outflows and new issue bond purchases, respectively.
Source: Barclays
At the sector level, supermarkets, pharmaceuticals, and energy-related credits outperformed in December, while retailers lagged. With respect to retailers, sector bellwether PetSmart was a focus capital structure for the market as prices of the unsecured debt declined ~16pts over the course of the month. The combination of uninspiring earnings (lower brick-and-mortar sales and profitability and continued uncertainty regarding Chewy.com’s path to positive cash flow) and an elusive earnings call (management instilled little confidence in both operating and financial strategies) inflated the requisite risk premium to own PetSmart debt. Supermarkets on the other hand made a last-ditch effort to generate positive returns for the year, though fell just short of the black. Supermarkets returned +2.55% in December, led by The Fresh Market, which saw bonds squeeze higher after posting results that were not too out of sync with already low expectations. TFM bonds, however, remain priced for future fundamental stress as the levered grocer attempts an operational turnaround while facing a growing competitive threat from Amazon/Whole Foods. Also posting solid returns in December were pharmaceutical credits with Valeant leading the charge higher. VRX unsecured bonds and stock were up +6pts and
+24%, respectively, during the month as investors grew increasingly confident in the company’s ability to grow and further deleverage
its balance sheet over the coming years. The company issued new unsecured bonds in December, refinancing near-term maturities
and more importantly proving to investors (both debt and equity) it can issue unsecured debt. Finally, the energy sector broadly
outperformed with investors feeling more confident (for the moment) in adding commodity risk as crude prices set fresh local highs.
Source: Barclays
Market Technicals
Fund flows remained net negative during December, extending the weekly string of outflows experienced in November. High yield
funds (ETFs and mutual funds) reported net outflows of -$2.1bn during the month, the majority of which was attributable to ETFs,
which reflect both absolute selling of high yield exposure as well as institutional investors selling HYG holdings to fund new issue cash
bond purchases. While this mix isn’t perfectly clear, there is no ambiguity in the data for full-year 2017, which shows the high yield
asset class lost ~$18bn in assets over the course of the year (a -$20bn net outflow from high yield mutual funds offset by a +$2bn net
inflow into HY ETFs). In fact, the high yield market was one of the only major sectors that saw capital leave in 2017, with stock, bank
loan and investment grade credit markets all experiencing large net inflows.
Fund Flows Were Net Negative in December, a Microcosm of the Large Exodus from the Asset Class in 2017
Source: Lipper, JPMorgan
New issue volumes were seasonally light given the marketplace was realistically open for just two of the four weeks during the month.
That being said, the market was active during those two weeks as issuers sought to lock in attractive financing in 2017 rather than
brave the unknowns (rates, spreads, fundamentals, technicals) of 2018. High profile deals during the month included Valeant, which
issued 8-year unsecured bonds at 9.25%, proving to the capital markets it could raise unsecured financing (at a level), and Mattel, a
fallen-angel which sought term financing in the high yield market to aid in its turnaround effort.
High Yield Net Supply ($MM)
Source: Barclays
Fundamental Trends
December capped off a mild-mannered year for default activity as generally accommodative capital markets buttressed less
durable business models and capital structures. With $16.7bn notional high yield bond defaults in full-year 2017, volumes were
the lowest since 2013, and stood in stark contrast with the commodity-led spike in bankruptcies and corporate restructurings in
late-2015/early-2016. The trailing twelve-month default rate (including distressed exchanges) finished the year sub-2% (1.45%
specifically per JPM).