Unless you have just been ignoring your Bloomberg terminal for the last few years, the fact that interest rates are literally at all-time lows should be no surprise. In the chart below we look at the yield on 10-year Treasuries going back 30 years. The yield on the 10-year Treasury hit an all-time low of 1.47% in July of this year.
For the last few years, many investors have articulated a bear thesis on U.S. government bonds based on the extremely low yields. For those that have actually implemented the thesis and shorted U.S. government debt, the trade was likely painful. In reality, shorting U.S. government bonds has been the proverbial “widow maker” trade over the past few years as bond prices have gone straight up and yields down.
Despite potential credit events, like the debt ceiling crisis in the summer of 2011 and a subsequent downgrade of U.S. government debt, yields on treasuries have continued to trend lower. The monetary policy implemented by the Federal Reserve has had the intended impact of keeping rates low and has, seemingly, made investors think that the Fed is the ultimate lender of last resort, albeit by printing money.
By keeping interest rates at abnormally low levels, not only has the Fed induced lower rates on U.S. government bonds, but it has also induced lower rates on many types of loans – from mortgages to corporate debt. In the two charts below, we highlight this by looking at the rates on 30-year mortgages going back 10 years versus a high yield US corporate bond index.
In some markets, like the residential mortgage rate, low rates have not increased money supply because of tightening lending standards. Conversely, the high yield market is, as they say, flush with liquidity. Related to that last point, in October the U.S. high yield primary market hit $41.9 billion in issuance. This trailed only September’s all-time high of $46.8 billion. Yes, you read that correctly . . . September 2012 was the highest month of high yield issuance in the history of capital markets. As of October, this year is 34% ahead of 2011’s full-year total and up 52% year-over-year through ten months.
Clearly, low rates are inducing corporate issuers to refinance at record rates. In fact, in the year-to-date 59% of total issuance of high yield debt has been utilized for refinancing. This is a little less than the 64% of proceeds used for refinancing in 2010, although in 2010 55% of proceeds were used to address maturities versus only 43% this year. So, corporations are taking advantage of the low interest rates to reduce their all in cost of borrowing. In addition, these issuers are taking advantage of the search for yield by many investors to sell record amounts of bonds.
Morningstar published their most recent fund flows data for flows through October. In the year-to-date, high yield fund inflows are +$27.9 billion and + $30.1 billion in the last twelve months. High yield is the second largest inflow category in the last twelve months after intermediate term bonds. On a percentage basis, though, high yield has seen the largest inflow of any of Morningstar’s top 95 asset categories growing 15.2% year-over-year.
The other interesting point relating to the high yield market -in addition to record low interest rates, record high issuance and record high yield fund inflows- is that terms for the issuers are almost as flexible as they have ever been. This is best characterized by the re-emergence of covenant-lite loans, or loans with much more lenient terms for borrowers. In the year-to-date, covenant-lite loan issuance is $49 billion. According to Fitch, the recovery rate for covenant-lite loans is 55 – 60% versus an overall recovery rate of 62% for loans from 2008 – 2009.
In aggregate, it seems like a frothy market for high yield, but high yield bulls would counter that the long term spread versus treasuries is not even close to its lows. The chart below from the St. Louis Fed highlights this point as it looks at the spread of high yield versus comparable duration treasuries going back to 1997. Currently, this spread is at 5.7% versus its low of 2.5% in 2007.
While the spread versus Treasuries is an important metric, the underlying creditworthiness is probably even more critical, especially with high yields bonds trading at their lowest absolute level ever. The caveat is that defaults rates are currently very low on high yield bonds. In fact, as of September the par weighted default rate, according to J.P. Morgan, fell to 1.83% and the issuer weighted default rate fell to 2.98%. This is well below the peak on par basis of 16.3% in November 2009 and the peak on an issuer basis of 12.2% in March 2002.
The reality is, though, that high yield bonds in aggregate are pricing in these low default rates. On absolute basis, high yield bonds are almost perfectly priced given their all-time lows in yield. So, investors are getting paid the lowest interest rate they have ever been paid to take the risk of owning high yield debt.
Our primary concern going forward relates to the corporate earnings and cash flow outlook. One of our three Q4 themes is that corporate earnings growth is slowing, which we highlight in the chart below and played out in Q3 with SP500 earnings only up 0.9% year-over-year. To the extent that corporate earnings and cash flow begin to decline year-over-year, this will have a direct impact on the ability of corporations to pay their interest rates on borrowing and adversely impact their overall credit worthiness.
In addition to the outlook for corporate earnings and cash flow, the other key red flag we see for high yield is that volatility for the asset class is starting to accelerate. By a recent estimate from ConvergEx Group, implied volatility for high yield bonds is up 64% in the last month. This comes even as yields for these bonds have continued to decline. Even if the high yield asset class is cheap on a relative basis, chasing high yield is far from a contrarian call at this point in the cycle, especially as corporate earnings look to be peaking.
Daryl G. Jones
Director of Research