US High Yield Market Review

Review of 2020

The US high yield market (as represented by the ICE BofA Merrill Lynch US High Yield Index) produced a 6.17% return in 2020, slightly better than the yield-to-worst at the start of the year, and in-line with the average coupon.  However, any casual observer of financial markets would recognize that 2020 was not a simple coupon-returning year.  The negative impact of Covid-19 and subsequent economic lockdowns, followed by the positive impact of unprecedented fiscal and monetary support, created significant volatility and opportunities during the year.   

 The US high yield market trailed equity indices and higher quality, longer duration fixed income indices in 2020.  Higher quality securities also outperformed lower quality securities within the US High Yield market, as BB, B, and CCC rated bonds returned 8.62%, 3.66%, and 2.86%, respectively.  The double B rated portion of the market benefited from Fallen Angels, which saw a large portion of their price declines happen while rated Investment Grade, and the following rebound in prices occurred while rated double B.  The longer duration of Fallen Angels and BB-rated securities also helped their performance relative to B-rated or CCC-rated securities.  Permanent losses from an increase in the default rate negatively impacted the returns of the lower rated portion of the market and the Energy sector.  However, the combination of defaulted securities leaving the index and a strong risk-on environment at the end of the year led to the significant outperformance of triple C and the Energy sector in the 4th quarter, closing some of the return gap for the full year 2020.

Breaking down the 2020 return into the sell-off that occurred in the 1st quarter and the rally that occurred the last 3 quarters of the year, we see a typical return outcome within our custom buckets under both time frames.  Once again, short duration securities showed how they can limit drawdowns in difficult environments, as was the case in q1 of 2020.  However, higher yielding and longer duration securities led the market higher for the remainder of the year.

Q1 2020:

Source: AXA IM, Factset, as of 12/31/20. Securities re-grouped monthly. 

Q2-Q4 2020:

Source: AXA IM, Factset, as of 12/31/20. Securities re-grouped monthly. 

2021 outlook

2020 reminded us that market outlook reports and investment plans at the start of a calendar year can become obsolete much sooner than expected.  The swift changes in the economy and asset valuations that occurred in March of 2020 quickly altered any strategic plans that were set at the beginning of the year.  We believe 2021 also calls for a flexible strategy in investing in the US High Yield market.  The severity of Covid-19 in the winter months, the progress made in distributing vaccines, inflation data and continued fiscal and monetary policy adjustments will all have the potential to shift economic forecasts and valuations rather quickly.  Similar to 2020, a strategy that can quickly adjust positioning during periods of volatility should prove successful in 2021.  

Amazingly, despite the volatility of the past 12 months, the market finds itself in a similar position today as it did this time in the previous year, from a valuation perspective.  Both 2020 and 2021 started the year with a historically low yield-to-worst and a significant portion of the market trading to its first call date.  Compared to a year ago, today’s market has a slightly higher spread, a lower yield-to-worst, fewer higher yielding securities and a higher percentage of longer duration securities.  Our custom market segmentation compares the two time periods below:

Undoubtedly the US high yield market’s return of 6.48% in the fourth quarter of 2020 took away some 2021’s return potential.  Despite a low yield-to-worst to start the year, we still think it is reasonable to expect a 4-6% return for 2021.  Our positive outlook for the US high yield market over the near to medium term hinges on the draught of high yielding opportunities in the current global fixed income environment.  The lack of yield in other global fixed income markets will continue to support demand for the US high yield asset class.  Combined with our expectation that net new issuance will be lower in 2021 than 2020, market technicals should continue to have a positive impact on spreads.  In addition, fundamentals should improve and the default rate should decline throughout the year.

A return above our expected 4-6% range would have to be an environment that includes a strong economic recovery, a significant rebound in sectors that were deeply impacted by Covid-19 (Energy, Leisure, etc.), and Treasury rates remaining near all-time lows.  A return below our range would be driven by either an increase in rates as the economy recovers (where HY outperforms IG and BB-rated securities underperform B and CCC), or a scenario where the distribution of the vaccine disappoints and the economy is slower to fully recover (IG outperforms HY, BB-rated securities outperforms B and CCC).     

In conclusion, the current valuation of the market leads us to structure a more defensive positioning to start the year, with a preference for shorter duration securities.  We continue to be cautious towards longer dated BB-rated securities that are trading to earlier call dates, as the negative convexity in these bonds is unappealing to us.  We also believe outperforming returns can be achieved by seeking off-the-run securities with idiosyncratic return potential, rather than chasing high beta securities from today’s valuations.  Flexibility is key in our strategy, as we expect to have the opportunity to pivot this positioning in favor of better valuations in some portions of the market in the future.