High yield entry timing
The COVID-19 pandemic has sent financial markets into a spin. We believe things may get worse before they get better. That said, historic crises can provide a useful guide to what might represent reasonable entry points and strategies for high yield bond investors in these volatile times.
In the wake of the current crisis spreads in the US high yield market most recently peaked at around 1,000 basis points (bp), or 10 percent, in March before retracing to levels around 800bp more recently. While spread volatility is likely to stay high, and current levels may not necessarily reflect the peak, history shows it pays off to engage well before the spread peak. In past crises, with the exception of the 2008 credit crisis (when spreads of almost 1,800bp were seen) and 1990, spreads also usually peaked at around 1,000bp.
Default rates braced to reach around 10%
Given the disruption and the negative economic impact of COVID-19 outbreak, default rates for high yield debt issuers are likely to increase substantially, towards 10-11% from their current 3% level, in our view. The increased potential risk of such a scenario is reflected by the high spread premium mentioned. While it is difficult to forecast future default rates precisely, past crises provide a reasonable guidance. In past distressed periods, default rates ranged between 10 and 15%. Even in the great recession in 1930, default rates for high yield bond debt issuers were around 15%.
Fed measures support part of the high yield market
The US Federal Reserve (Fed) has unveiled large scale liquidity measures which should provide some support to the high yield market in the short to medium term. The initiative has already aided a recent recovery in spreads. The corporate bond purchasing facilities, for example, now include part of the high yield bonds (known as “fallen angels” – investment grade bonds which have been downgraded to high yield status) and high yield exchange-traded funds.
Engaging too early is equally as bad as waiting too long
The optimum entry point could be defined at the point when spreads are at the widest levels and prices are at their lows. But this entry point is only known in hindsight. Historical patterns during crises illustrate that starting investing at a level when spreads widened by only 50% from the low to the peak has resulted in very positive returns in subsequent years.
Every crisis is different but performance patterns are similar
While every crisis is usually different in terms of magnitude, speed of recovery, spread level or ultimate default rate, performance in subsequent periods show similarities. The total return of the respective high yield index already accounts for losses from factors such as default rates and spread widening.
Guessing the mid-points rather than the spread peak
Assuming that recent 800bp high yield spreads are halfway between their low and peak for the COVID-19 crisis, then this implies that the peak this time would be almost 1,300bp (which is at the higher end in an historical context). By accepting that another 50% widening is possible, the risk of missing a good entry point is mitigated while laying a foundation for possible positive turns (see table).
Waiting for the peak means ignoring potential positive surprises
Amongst all the doom and gloom, an affordable and effective vaccine may be established within 18 months. We have already seen some positive news around effective symptom treatments, for example. While a vaccine would take time to be rolled out, high yield spreads would move quickly on the back of the news. While this should not be regarded as a base case for now, the chances of a vaccine emerging should be considered when deciding whether to invest now or to wait for a “better” moment.
Diversification and active management remains key
We expect high yield bonds to stay volatile for some time, while offering the potential for attractive positive returns in the long run following their dramatic spread widening. While aiming to take advantage of relatively higher spreads and yields, it is prudent to diversify and use active strategies to mitigate default risks and to optimise returns.
While active fund managers are likely to avoid, or be highly selective in, the most vulnerable sectors, like energy for example, private debt fund managers typically hold cash in extremely volatile periods to find specific situations in which they can invest in a distressed price environment.
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