The high yield credit market is on fire! It's been a full participant in the Trump Rally. But the question is - what are the drivers of return for the asset class? And what risks are you taking by exposing yourself to high yield credit? And are these drivers likely to continue in 2017?
A good place to start is to look at one of the most popular US high yield ETFs, its ticker is, rather aptly, JNK. What draws investors to high yield is the income, and the distribution yield on this ETF is currently over 6%. In a world where cash is still returning less than inflation that high income is very attractive. A second attraction is the price of the funds is rising sharply adding to profits for investors that bought last year. There was a massive selloff in US high yield at the beginning of 2016 as oil prices plummeted. US high yield credit made a spectacular comeback giving a return of about 16% in 2016. Naturally, investors are flocking into this asset class drawn by the income, price momentum and the tail-wind of the Trump Reflation Rally. It might be junk, but it's junk that's on fire!
If we look under the hood of the JNK ETF we can see the top ten holdings out of the 824 bonds held by the fund. These tend to be low-quality credits, that's why it's called a junk bond. One of the names in the "Top 10 Holdings" at the bottom of the image is Western Digital, and to get an insight into why this company's bonds are high yield we'll dive into its financial fundamentals.
This is the summary in ShareScope for Western Digital corporation. It has gearing of 152%! That really is quite alarming. Gearing is a measure of balance sheet risk. The way that a company is funded determines its riskiness. A company with a lot of equity and very little debt has low risk. By taking the ratio of debt to equity we have a nice measure of the balance sheet risk of the company.
So here are two example balance sheets, on the left a weak one on the right a strong one. This is the liability side of the balance sheet; this is how the company is funded (I've simplified it a great deal). The important thing to understand is that if the company makes a loss on its assets it's the equity that absorbs that loss. Once the equity is wiped out the company becomes bankrupt. Think of equity as a shock absorber. The bigger the shock absorber the safer the balance sheet.
If there's a lot of debt on the balance sheet the company is highly geared. This means there's a higher risk of default and bankruptcy and the debt of that company is classified as high yield credit. If there's not much leverage and there's low gearing then there's a low risk of default and the company's bonds are described as investment grade credit.
Gearing has a direct bearing on the yield of a bond. Again we've got the high gearing company on the left and the low gearing company on the right. And the height of the bar is the yield on the bonds, or, as an investor, the income you receive. You can see that for high yield a large part of the income is made up of the credit spread. That's the compensation you receive for taking the risk of losing money if the company defaults on its debt repayments or goes bankrupt. The reason the credit spread is large is because it's compensation for you, as the investor, for taking the risk of that company's default.
For junk bonds a small part of the yield is from the risk-free rate which you can think of as the interest rate you would receive on a government bond. Another large component is the liquidity premium. High yield credit tends to be very illiquid. In a crisis it's very difficult to sell high yield bonds. That's a big risk for high yield investors, so they demand compensation for that illiquidity. Compare that with the investment grade yield on the right hand side. You can see that the credit spread is tiny. You're taking a small risk of default so you receive a smaller compensation for taking that risk. The risk-free rate is just the same as it would be for a high yield bond, but you can see that it's a bigger proportion of the all-in yield for investment grade. And that's why investment grade credit tracks government bonds quite closely, particularly at the moment because risk-free rates are so small and credit spreads are very tight.The liquidity premium on investment grade credit is also smaller than it is for high yield. That's because investment grade credit tends to be more liquid than high yield bonds.
Here I've shown the return on three different ETFs. The SPY ETF (red) tracks the US share market, the S&P 500. JNK we've already seen tracks the junk bond market (green), and LQD (blue) tracks the investment grade credit market. There are three dotted vertical lines. The first one on the left is the default of Lehman Brothers in September 2008. You can see that post-Lehman shares fell the most, then high yield credit which tracked shares very closely, and finally investment grade credit which fell the least - only by about 30% versus 50% for high yield and for shares.
A more recent turning point was at the beginning of 2016 when oil reached its low-point of about $27 a barrel. High yield was heavily exposed to oil prices, it was almost tracking it one-for-one because a lot of shale-oil companies in the US had been funded through junk bonds and when the price of oil fell they were no longer financially viable. As oil rallied so did the junk bond market.
Shares and high yield track one another very closely. In fact credit can be seen as a canary in the risk coalmine. When junk sells off equity is never far behind. And for that reason alone it's very well worth tracking the JNK ETF.
What you can also see is that during the Trump Rally both US shares and junk rallied very strongly whereas the investment grade market fell sharply because yields had started to increase on government bonds. Remember risk-free rates are a big part of investment grade yields and as the yields rise the price of the bonds falls.
A big story at the moment is the investor stampede into the high yield market. You can see the all-in yield is now reaching 10% after spiking up to 22% at the beginning of 2016 when oil approached its nadir.
Trump's policy of cutting taxes is beneficial for high yield bonds just as it is for the equity market because more profit means a greater ability to service debt. So the probability of default drops.
Do you think high yield is toxic? Is this stampede just building a bubble? Or is high yield credit a safe source of income? You can tweet us @PensionCraft or message us on Facebook with your thoughts. We look forward to hearing from you!