The opportunity to visit with clients and prospects with exceptionally diverse backgrounds and personalities is one of the most interesting facets of our job. No two meetings are the same, and the thought-provoking discussions ensure that our profession never goes dull. Question topics range from broad market views to credit-specific details, with everything in between. In this newsletter, we address the questions that seem to be asked most frequently and/or we believe are particularly relevant in the current market environment.
In your opinion, is the current high yield market compelling? Relative to history, high yield valuations are less attractive than average but high yield fundamentals are more attractive than average (technicals are average). Also, the forward yield curve provides some reason for caution. Our collective view on the high yield market, therefore, is positive but tempered. Valuations
The current yield (coupon rate divided by the average price) of the high yield market1 as of 12/31/2013 was 7.1%, which is well below the long-term average of about 10%. Adjusted for the low interest rate environment, however, the current yield is in line with historical averages. The current yield represents the income scheduled to be paid to bondholders. The actual amount paid to bondholders is less than this amount, however, due to bond defaults. This leads us to fundamentals. Fundamentals
The default rate on the high yield bond market closed 2013 at 0.66%—well below the long-term average of approximately 4%2. Strong profitability, reasonable financial leverage, and extended debt maturities have combined to keep default rates benign. We have witnessed subtle signs of more aggressive issuance, however, and believe defaults will rise modestly but remain below long-term averages. If the default rate rose by 100 basis points and the post-default recovery rate remained at historical average levels (~40%), the amount of yield that investors actually received would decrease by about 1%. Forward yield curve
According to the forward Treasury curve, the market expects the yield on similar-duration Treasuries to increase by about 80 basis points. Based on the duration of the high yield market and historical correlations, the amount of yield that investors receive would decline by another 1%, approximately. In sum, if we reduce the current yield to compensate for default losses and rises in interest rates we would arrive at a rather modest figure. Default losses and interest rate changes are highly uncertain and not guaranteed, however, and could materialize in a considerably different fashion than the scenarios described above.
