In a year when bond yields have fallen dramatically after the Federal Reserve (Fed) cut the Fed funds rate to a range of 0 – 0.25% – the lowest rate in U.S. history – high yield bonds still offer some relatively attractive rates for investors.
“This year has been volatile, as in all markets,” explains Paul Ocenasek, senior portfolio manager of the Thrivent High Yield Fund (LBHIX). “Spreads started the year at about 330 basis points over the treasury index and widened to about 1,100 over in March when we had the economic shutdown. That was the steepest, quickest sell-off we’ve had in high yield – it only took about a month to widen that much.”
Since then, as the Fed continued focusing on fiscal and monetary programs in an effort to buoy the economy in the face of the COVID-19 pandemic, spreads started to drift back down to just under 500 basis points over where they had been for the past several months.
Recently spreads rallied down to the low 400 basis points on favorable vaccine news said Ocenasek. “Spreads are a bit below their 10-year and 30-year averages but still well above historical lows. From that stand point, the high yield market looks fairly attractive based on where it has traded historically.
“Although those spreads are only about 50 basis points below their averages,” he continued, “the yields in the high yield market are still pretty low by historic standards, but that 4 - 6% yield in the high yield market is still very attractive versus other fixed income areas – especially given that the duration in the high yield market is about 3.5 years, which is quite a bit shorter than the investment grade bond market.”
Risk and default rates
Default rates have increased significantly in 2020, which would be expected given the unfavorable economic environment.
“The high yield bond market began the year with a default rate of around 3%,” recalled Ocenasek. “For much of the past 10 years, the default rate was around 1 - 2%. It ticked up at the end of last year and continued to climb to a default rate of about 6.5%. Moody’s projects that the default rate will peak in the first quarter of 2021 at around 8%. One thing to keep in mind is that default rates are a lagging indicator, so most companies that are going to default already dropped in price in March to distressed levels, and that has been reflected in the total return of the Thrivent High Yield Fund year-to-date. So, we don’t expect a lot more total return damage from an increasing default rate over the next several months. Those companies have already traded down.”
While there has been more volatility than usual in the high yield bond market, most of that volatility has been in just a handful of industries, such as energy, retail and telecom.
“When we talk about volatility, we’re referring to a little sharper movements in the price of bonds,” said Ocenasek. “But despite the volatility, the market is acting quite healthy. We’ve had record issuance this year already. We expect to come in at over $400 billion new issuance in the high yield market.
“Spreads have been declining lately, which is also evidence that things are healthy,” he added. “And trading volume is quite high, so people are able to buy and sell bonds – nothing has frozen up.”
Ocenasek believes there are several unique opportunities in the high yield bond market this year that are normally not available during volatile economic periods.
“Several industries have been directly impacted by COVID-19 – such as airlines, cruise lines, hotels, and retail,” he explained. “They have come to the high yield market and issued short paper – three- to five-year paper that is secured. And it’s quite high yielding. That’s unusual for the high yield market. Usually we see eight- to 10-year paper that is issued and it’s unsecured.
“One example would be Carnival Cruise Lines, which issued paper earlier this year with 3-year first lien paper that had an 11.5% yield,” he added. “And they issued more bonds after that with yields of 10% or a little over. Royal Caribbean and Norwegian cruise lines did essentially the same thing.
“The airlines have also tapped the high yield market at anywhere from 4.5% to 11.5% to fund their operating losses,” said Ocenasek. “And any large retailer that has access to capital – Macy’s, Gap, The Limited – has tapped the high yield market with bonds that are above the average of 4% to 7%.”
About $150 billion in high yield bonds have been issued this year from fallen angels – investment grade companies that have been downgraded in the market.
“That has provided us with some interesting opportunities,” said Ocenasek, “because there is typically a transition period of higher volatility and dislocation as certain funds are selling out or selling down. These companies typically have a much larger capital structure and larger public equity value than a typical high yield company, which means they have a lot more options available to access liquidity, so they’re really interesting opportunities.
“For example, one of the largest issuers of high yield this year was Occidental Petroleum,” he added. “When they were downgraded, they came into the high yield market yielding over 14% in their 10-year bonds. After the market stabilized, they issued a new 10-year bond at 8 7/8% to refinance their near-term maturities. There have been others, as well, such as Kraft Heinz and Ford. Ford was yielding over 10% when it was downgraded, and it is still yielding quite a bit more than the average BB bonds.”
While the bond market may continue to encounter some volatility in this unusual economic environment, the high yield market offers some compelling investment opportunities worth considering.