To say the past decade has been an eventful one for the high yield market is putting it somewhat mildly. The first half of 2007 was a golden time: markets were in rude health making pre-crisis highs, politicians were for the most part sane, competent, normal human beings, and a eurozone crisis involved accidentally skiing to a Swiss après-ski bar. The following decade has not been quite as smooth, enduring as we have the global financial (2008/9), eurozone (2011), and energy and commodity crises (2014/15) of recent years.
Yes – those were happy days indeed, but with the benefit of hindsight, a seemingly terrible time to buy any risk asset. Within high yield, valuations in 2007 were at their most extreme with the additional yield on offer from high yield bonds (versus similar maturity government bonds) at its all-time low of 2.3%, versus around 4% today.
Taking a closer look at how the asset class has actually performed from this ‘terrible’ entry point illustrates much about the source of returns within high yield.
Global High Yield: 10-year returns
Source: BoAML Global High Yield Index, Bloomberg. USD. 31/03/2007 to 31/03/2017.
A few things stand out. First is the impressive total return of 110%. To be sure, there were some hugely volatile periods, none more so than the dramatic – albeit brief – near 40% drawdown in early 2009, as well as of course 2011 and 2015. These periods can have a big impact on the short-term price performance of the asset class. But in the context of long-term total returns, we can see that price volatility is dwarfed by one, compelling source of return – carry.
Of the 110% you have made in high yield over the past decade, some 112% of it came from income, and recall that this was from a ‘terrible’ time to buy!
The key to exploiting the carry in high yield is to stay invested – sorry, no carry for day traders – and adopt an active approach to selecting the companies you wish to lend to. Remember, high yield is at its core a mechanism for transforming the real-world cash flows of cash generative companies into coupon flow for investors who provide debt financing. Given we have long known this about the high yield market, it is why we emphasise these very cash flows when selecting companies to invest in.
Perhaps it is asking too much for financial journalists to lead with ‘Massive Coupon Income Hits HY Market’; but we do think investors should keep this in mind when they next read about the ever-present impending doom of the high yield market.
OK, so “Billions” is actually produced by Netflix competitor Showtime, owned by CBS and broadcast in the UK by Sky Atlantic. However, yesterday, Netflix issued its debut bond into the Euro market with €1bn of 3.625% 10 year bonds using its B1 rating. What is unusual with Netflix is its vast market capitalisation at $63bn is often associated with materially better rated companies.
Netflix being one of the FANGs (The new tech stock of Facebook – Amazon – Netflix – Google) is still in build-out phase as it aggressively invests overseas to capture market share. Whilst subscription revenues are evenly divided between the US and the rest of the world, US profits subsidise overseas expansion with top line growth of up to 30% – which is a key ingredient to its huge market capitalisation. The pricing was fairly aggressive for a B1 issuer, but the halo effect of being a FANG means the deal isn’t breaking bad as it is around ¾ point higher today. The Crown in yesterday’s European high yield market.
UK retailers are facing significant pressures over the coming years – from the rise in business rates, higher supplier costs due to weaker sterling, and the new national living wage; to the expected continued growth of online retailers like Amazon and Asos. Given all that is facing these companies anyway, investing in the more indebted end of the sector seems to us a costly mistake at present. We would argue that retailers in general tend to have high fixed costs and variable top lines, so adding a large fixed debt service cost generally doesn’t stack up. Interestingly though, the market doesn’t seem to agree with what we would regard as common sense, as the median UK high yield retailer has debt worth almost six times their earnings – significantly above the European high yield average of just over four times.
Despite the fact that UK high yield retailers are facing huge operational headwinds alongside significantly more indebtedness than the wider high yield universe, the bonds on offer do not trade at a discount – in fact when we checked on Friday the median UK high yield retail bond traded with exactly the same spread over government bonds as the wider European high yield market!
In short the bonds of UK high yield retailers offer significant operational risks; large levels of indebtedness; and absolutely no discount to the wider market. We’re quite happy to let the benchmarked funds and ETFs play away in these, and think that our clients are getting far better service by looking at other more attractive parts of the high yield market.