While obviously a challenging market environment, we believe that high-yield bond and bank-loan spreads, in the 97th and 98th percentiles, respectively (as of this writing), could more than compensate investors for forward-looking potential credit losses.1
- In the case of bank loans, an average market price of around 782 seems to imply that investors are expecting more than 50% of the market to default. However, the worst five-year cumulative default rate for loans historically has been 25.3%.3
- Additionally, investing in high yield at spreads over 1,000 basis points (bps) and then staying invested for three or more years has historically produced annualized total returns of at least 14%.4
- As a result, despite today’s challenges, we believe there may be compelling long-term value in the high-yield and bank-loan markets.
As of March 25, the high-yield and bank-loan indices were down between 9% and 11% over the past week and between 17% and 18% on a month-to-date basis. Month to date?, high-yield and bank-loan spreads had widened by over 500 bps, with the commodity-sensitive sectors widening the most. The average bank-loan price was 78, while the option-adjusted spreads of the global and US high-yield indices were both over 1,000 bps. European high-yield spreads were a bit lower (799 bps), due primarily to a lower energy-sector weight versus global and US high yield.
Given that bid-ask spreads have been around 4x a normal market environment during this crisis, we are mindful of the higher costs of trading. However, we think there may be opportunities to add risk on the margins. In particular, we prefer businesses that are likely to be fundamentally healthy over the long term and have ample liquidity in the near term. In addition, we have begun to see increased dispersion in the high-yield and bank-loan markets, which we believe could favor some fundamental-based investment approaches.
Furthermore, we expect to see some investment-grade-rated companies being downgraded to high-yield status in the coming weeks and months. We believe that many of these investment-grade downgrades will present opportunities to invest in relatively high-quality companies at potentially attractive valuations.
Looking forward on the economic front, we think it is increasingly likely that the global economy is entering a recession due to the mounting impact of the coronavirus pandemic. As a result, we anticipate that high-yield and bank-loan defaults over the next 12 months may well rise toward previous recessionary levels. We think many of these defaults are likely to occur in the commodity-sensitive sectors (e.g., energy, metals, and mining), as well as in the retail sector.
1High-yield and bank loan spreads are as of 25 March 2020. | 2Bank-loan prices are based on the S&P/LSTA Leveraged Loan Index. | 3Five-year cumulative default rates are based on annual default rates for the S&P/LSTA Leveraged Loan Index from January 1999 – February 2020. | 4Three-year forward return observations are based on the Bloomberg Barclays US High Yield Index. This analysis reflects the forward three-year total returns of the index since each month-end option-adjusted spread observation beginning 31 January 1994. The use of alternative time periods would yield different results. The spread level of the index was 1.025 basis points on 25 March 2020. Indices are unmanaged and cannot be invested into directly. | 5US high yield is represented by the Bloomberg Barclays US High Yield 2% Issuer Capped Index, European high yield by the ICE BofA/Merrill Euro High Yield Constrained Index, and global high yield by the ICE BofA/ML Global High Yield Constrained Index.