High Yield Spreads Passed a Significant and Rare Threshold

The COVID-19 global market selloff marks only the eighth time in 20 years that high yield spreads widened to over 800 basis points.

As the extreme and widespread volatility caused by the COVID-19 global pandemic continues to roil markets world-wide, we believe that current high yield bond market conditions represent a rare value-buying opportunity that could carry long-term, positive implications. While spreads widening to over 800 basis points (bps) may seem daunting, such rare events have historically followed a similar pattern of widening before rapidly tightening again. On that note, we believe that strong overall credit fundamentals and generally solid high yield performance in the run-up to the pandemic make today’s valuations attractive compared to previous episodes of spread widening. While uncertainty is likely to prevail over the short-term, history has shown that getting in early on such opportunities is crucial. We therefore believe that now is when investors should strongly consider enhancing their high yield bond positions.

Rhymes (but not Repeats) in Recent History

Over the past 20 years there have been eight periods, including the current, in which events drove high yield bond spreads above 800 bps over Treasuries. While the dynamics driving each event were unique, they all created deep technical valuation suppressions that have historically offered swift and significant risk-adjusted performance. Using the collapse of Lehman Brothers in September 2008 as an example (Figure 1), if an investor entered into a high yield position on August 31, 2008, i.e. the last day of the month prior to spreads widening to over 800 bps, they would have participated in what ended up being a long-term rally. However, the timing of the allocation to high yield is crucial. Once spreads start to tighten, they have historically gapped quickly, as shown by the number of months spreads have remained in 800bp territory in Figure 1. This illustrates that it’s better to be early to the trade than late, so as to not miss the opportunity. Indeed, the recovery came on even more rapidly, despite the magnitude of the shock of that the event.

Figure 1. High Yield Positioning Prior to Spreads Spiking Over 800 Basis Points (Total Return)
Figure 1. High Yield Positioning Prior to Spreads Spiking Over 800 Basis Points (Total Return)

As of March 31, 2020. Source: Bloomberg Barclays and Voya Investment Management. Note: In 2008, spreads widened to 800bps in March, fluctuated in August, and then re-widened in September. The table only captures the August 2008 widening.

In this context, history shows that momentum is a two-way street. Similar to selloffs, as buying builds and spreads begin to tighten, they have historically gapped tighter, illustrating that it’s better to be early to the trade than late, so as to not miss the opportunity.

But as with any approach to timing a market dynamic, getting in early and then waiting can be daunting and costly. However, we note that in the case with high yield bonds, any further drawdown immediately following the initial trade is cushioned by the sector’s high coupons. Not only does this provide monthly income in the interim, it can also mitigate equity market drawdowns, thus helping to manage overall portfolio volatility.

Better Fundamentals This Time

One crucial difference between the current market environment and previous spread widening periods is the generally strong fundamental position of the high yield market prior to the emergence of the COVID-19 pandemic.

Per Figure 2, nearly 50% of the high yield index is rated Ba (or BB). In 2011 less than 40% of the high yield market was rated Ba (or BB), and in 2016 this figure was just over 40%. We believe the overall market’s relatively higher credit quality make this opportunity to allocate to high yield even more compelling for asset allocators.

Figure 2. Ratings at Spread Levels Entering 800bp Periods
Figure 2. Ratings at Spread Levels Entering 800bp Periods

As of March 31, 2020. Source: Bloomberg Barclays and Voya Investment Management.

Furthermore, as of December 31, 2019, high yield bonds posted positive returns in 14 of the 16 quarters, as measured by the Barclays High Yield Bond Index. That said, while the overall market was performing well prior to the outbreak of the global pandemic, prudent security selection remains critical no matter what market prevailing market conditions may be. At current high yield market volatility levels, sector dispersion has reached post-recession highs (even excluding energy), highlighting the importance of active management navigating through increases in distress and defaults in the market.

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This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) changes in laws and regulations and (4) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors. Past performance is no guarantee of future results.