Weekly Global Market Commentary – 19th October 2015

Time for High Yield – By Bryan Dooley, CFA

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Amidst two mega-merger announcements and somewhat mixed economic data, global equity markets forged ahead by about one percent last week, making the third week in a row that stocks have rallied and bringing the total up to a five percent increase as measured by the S&P 500. After some early signs of stabilization in securities prices, now looks like a good time to consider one out of favor group of securities.

When the global economy is riding high and credit problems are low, they are called ‘high yield bonds’ but when we hit a rough patch and defaults are on the rise, they are referred to simply as ‘junk bonds.’ The class of lower grade, higher yielding fixed income seems to come in and out of favor at various times during each economic cycle. Yet, this often overlooked asset class has increasingly found a place in many widely accepted investment strategies and the timing now looks about right for adding positions.

When considering this category, investors should understand the sector encompasses a wide swath of individual securities. For starters, the standard definition of ‘high yield’ refers to any bond rated below investment grade, defined as ‘BBB’, by either of the two main credit rating agencies: Moody’s and Standard & Poor’s. In general, credit ratings begin at ‘AAA’ for the highest quality, most secure bonds and, similar to a high school report card, fall all the way down to ‘D’, which means the security is in default. Thus, a security lumped into the ‘high yield’ bucket might be hovering just under investment grade at BB+, or teetering on the brink of insolvency at CCC-.

While most high yield bonds are still current on interest payments, the lower a bond’s rating, the higher the probability of a default somewhere down the line. Therefore, in order to compensate for the higher risk, these bonds must pay higher rates of interest in order to attract potential investors.

The timing may now be about right to start a position in high yield in light of today’s lower prices and higher rates of interest being offered. The metrics on this asset class are especially attractive when compared to the steadily declining yields on the highest quality bonds.

The BofA Merrill Lynch U.S. High Yield Master index, somewhat of an industry standard, is presently yielding 7.6%, or about 6.5% more than the benchmark ten-year U.S. Treasury yield which has fallen to just over two percent at present.

By comparison, in June of last year the BofA HY index reached a low yield of 4.84% while the Treasury bond yielded 2.5%, giving high yield investors an edge of just 2.34%. The difference or ‘spread’ between Treasuries and corporate debt is a key metric in evaluating the attractiveness of this category.

Interestingly, the trough in high yield spreads last year coincided almost perfectly with the peak in oil prices several months ago. Since oil prices began plunging late last year, investors have fled the high yield sector on concerns that falling commodities prices would imperil many overleveraged energy concerns. Indeed, energy-related defaults have risen this year and now total 12 for the first half of 2015 according to Moody’s. The current number of defaults

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