Charting the Market: As High Yield Spreads Compress, Consider Senior Loans


While oil price declines roiled the energy-laden high yield market at the end of 2015, high yield debt bounced back in 2016, posting a 17% return.1 This enabled the high yield market to keep its streak of never reporting back-to-back years of losses alive.2 It also led to a significant tightening of credit spreads, rewarding investors who had steel stomachs and were willing to take on risk at a time when rating downgrades were approaching crisis-era 2009 levels.3

The question, however, is how much more can high yield run in 2017 as spreads compress? And by flocking to high yield, are investors chasing income without keeping an eye on credit risk?

Tracking the decline of high yield credit spreads


As shown in the chart below, high yield credit spreads have tightened by more than 310 basis points in the last year. Energy high yield debt spreads have tightened by more than 890 basis points and are now back to levels witnessed prior to the energy meltdown of 2015. 

Feb Chart Pack - Graph 1

Source: St. Louis Federal Reserve, Bloomberg Finance L.P., State Street Global Advisors, as of 2/8/2017
Past performance is not a guarantee of future results. Ratings defined by the composite of S&P®, Moody’s and Fitch Index returns are unmanaged and do not reflect the deduction of any fees or expenses. 
Index returns reflect all items of income, gain and loss and the reinvestment of dividends net of withholding taxes and other income. 

This recovery in "junk" bonds is widespread across all high yield rating spectrums and, as shown below, has pushed broad high yield spreads below 400 basis points—a level 24% lower than their 20-year median.4 

Feb Chart Pack - Graph 2


Source: Bloomberg Finance L.P., State Street Global Advisors, as of 2/8/2017
Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.

It appears investors are ignoring the impact of spread compression and searching for yield without regard to credit risk, a notion underscored when looking at the spread between CCC-rated debt, the riskiest high yield slice, and broad high yield. That spread is less than 500 basis points, tightening by 50% in the last year.5

Feb Chart Pack - Graph 3


Source: Bloomberg Finance L.P., State Street Global Advisors, as of 2/8/2017
Past performance is not a guarantee of future results. Ratings defined by the composite of S&P, Moody’s and Fitch Index returns are unmanaged and do not reflect the deduction of any fees or expenses. 
Index returns reflect all items of income, gain and loss and the reinvestment of dividends net of withholding taxes and other income. 

Admittedly, income generation is still necessary, and some of the ills that ailed the high yield market at the start of 2016, like energy prices, have dissipated. But investors may now be taking undue risk to gain higher yield where there may be more downside than further upside. The chart below helps illustrate this point.

Feb Chart Pack - Graph 4


Source: Bloomberg Finance L.P., State Street Global Advisors, as of 2/8/2017
Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.

This chart shows the average forward 12 month returns for the BofA Merrill Lynch US High Yield Index based on the spread levels at the start of the 12 month period. When credit spreads are between 300 and 400 basis points, high yield bonds returned 5% over the next 12 months, on average. Conversely, spreads wider than 1,000 basis points have, on average, returned roughly 47%. 

Today we are in the later stages of a credit cycle and spreads are in the sub-400 basis point level. The 17% return of 2016, when spreads were north of 900 basis points, may be hard to come by. 

In the late credit cycle innings, make it a "Game of Loans"


For income at a reasonable risk in 2017, investors may want to consider floating over fixed rate solutions. Senior loans are floating-rate debt issued by corporations and backed by collateral. While their credit quality is often below investment grade, similar to high yield, senior loans are ahead of high yield debt in the event of issuer default. This means senior loans have a higher recovery rate than traditional high yield bonds.

If credit spreads widen and the market takes a risk-off tone, senior loans may outperform high yield. The figure below shows that since 1993, when credit spreads on high yield bonds have widened during a month, senior loans, on average, have outperformed high yield bonds by 0.59%. In the 20 months when spreads widened the most, senior loans had a far less negative performance—potentially preserving more yield in a portfolio's speculative grade credit bucket.

returns during different spread environments


Source: Bloomberg Finance L.P., State Street Global Advisors, as of 12/31/2016
Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.

Investors can access senior loans with the actively managed SPDR® Blackstone / GSO Senior Loan ETF (SRLN). Passive exposure to senior loans will simply mirror the size and liquidity preference of an index without concern for credit quality. But credit quality is one of the most important attributes in senior loan investing—even more so in these later credit cycle innings.

Last year delivered increased default rates and a spike in rating downgrades. This year, the potential for rising interest rates may affect issuer re-financing costs. That means now is not the time to compromise on quality in the high yield space in the quest to generate income. 

For more investment insights, be sure to follow SPDR Blog and access our monthly Chart Pack, which provides additional views into evolving market trends.

1Bloomberg Finance L.P., as of 12/31/2016, based on the BoFA Merrill Lynch US High Yield Index
2Bloomberg Finance L.P., as of 12/31/2016, based on the BoFA Merrill Lynch US High Yield Index 
3Bloomberg Finance L.P. as of 12/31/2016, there were 823 rating downgrades by S&P for high yield issuers in 2009, vs. 452 in 2015 and 696 in 2016
4Bloomberg Finance L.P., State Street Global Advisors, as of 2/8/2017
5Bloomberg Finance L.P., State Street Global Advisors, as of 2/8/2017

Definitions


Bank of America Merrill Lynch US High Yield CCC or Below Rated
A subset of The BofA Merrill Lynch US High Yield Index including all securities rated CCC1 or lower.

Bank of America Merrill Lynch US High Yield Master II Index
An Index that tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch).

Bank of America Merrill Lynch US High Yield BB Rated
A subset of The BofA Merrill Lynch US High Yield Index including all securities rated BB1 through BB3, inclusive.

Bank of America Merrill Lynch US High Yield B Rated
A subset of The BofA Merrill Lynch US High Yield Index including all securities rated BB1 through B3, inclusive.

Bloomberg USD High Yield Corporate Bond Index Energy
The energy subset of The Bloomberg Global High Yield Corporate Bond Index.  The Bloomberg Global High Yield Corporate Bond Index is a rules-based, market-value weighted index engineered to measure the non-investment grade, fixed-rate, taxable, global bond market.  The base currency is USD.

Bloomberg Barclays U.S. Corporate High Yield Bond Index
A benchmark that measures the US corporate market of non-investment grade, fixed-rate corporate bonds. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below.

Credit Suisse Leveraged Loan Index
An index designed to mirror the investable universe of the $US-denominated leveraged loan market.

Floating Rate Notes 
Debt securities designed to protect investors against a rise in interest rates, but also carry lower yields than fixed notes of the same maturity. The interest rate for a floating rate note resets or adjusts periodically (normally on a daily, monthly, quarterly or semiannual basis by reference to a base lending rate).

High Yield Bond, or Junk Bond
A high paying bond with a lower credit rating than investment-grade corporate bonds, Treasury bonds and municipal bonds. Because of the higher risk of default, these bonds pay a higher yield than investment grade bonds.

Option Adjusted Spread, (OAS)
The measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate. The spread is added to the fixed-income security price to make the risk-free bond price the same as the bond. This is a measurement tool for evaluating price differences between similar products with different embedded options.

Senior Loans
Floating-rate debt issued by corporations and backed by collateral such as real estate or other assets.


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