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High Yield Update: Pricing for Recession?

Bill Zox, CFA, and John McClain, CFA
March 16, 2020

A lot has happened since Friday morning, including the Fed cutting the fed funds rate an additional 100 basis points (bps) to near zero, announcing a quantitative easing program and coordinating with other central banks to provide dollar liquidity globally. The S&P 500® Index was up close to 10% on Friday, but futures are once again limit down (-5%) as we write this. We are focused on the following factors: (1) corporate bond prices, (2) liquidity conditions in financial markets, (3) monetary and fiscal policies globally, (4) virus news flow and (5) economic and corporate earnings data points.

Let’s start with corporate bond prices. At Friday’s close, the option-adjusted spread of the ICE BofA US High Yield Index was 731 basis points (bps) and the yield-to-worst was 8.2%. (The option-adjusted spread is market-cap weighted difference between the index yield and the Treasury spot curve, adjusted for option payments.) We may soon get close to a 900bps spread—an especially significant level. During the financial crisis, we first hit 900bps on September 15, 2008, the day Lehman Brothers filed bankruptcy. The index fell 30% over the next three months until the high yield market bottomed on December 15, 2008. But by September 15, 2009, one year after the 900bps breach point, the index was up 10%.

We consider the 900bps spread level to be priced for recession. In our judgment, the index spread went from 900bps to 2,182bps in the financial crisis due to a series of policy errors that caused legitimate concern that the US banking system would be nationalized. In 2011, we priced for recession and avoided it, so 910 represented the bottom of the high yield market then. In 2016, we also priced for recession but avoided it, and the high yield market bottomed at an 887 spread.

The 2000-2002 cycle was actually the most difficult for long-term investors because the market double-dipped. The high yield market was priced for a recession in 2000 as the economy was near recession—then the actual recession came in 2001. But even in those difficult conditions, 900 basis points was a good starting point for long-term investors. We don’t think that 2011 and 2016 are the best analogs for today. However, we do think that policymakers have learned important lessons from the financial crisis and the banking system comes into this environment in a much stronger financial position.

The following table shows the last three initial 900bps spread breaches and the 2016 spread peak (a level not seen outside the other three breaches), returns from that point to the index bottom, then forward returns from the breach dates.

Source: Federal Reserve Bank of St. Louis and Morningstar Direct, as of 2/29/2020. Returns greater than one year are annualized. Spread is based on the ICE BofA US High Yield Index option-adjusted spread.

Combining corporate bond prices with global monetary and fiscal policies, we doubt that policymakers have found the right policy mix but we are confident they will. Less than one month ago, the US high yield market had a yield-to-worst of 5.2%. Today the yield is getting close to 9%. Policymakers are highly motivated to get that yield-to-worst much closer to 5%. At 9%, there is a significant social cost because it affects not only high yield corporate borrowers but also the cost of capital for smaller private businesses and consumers. We expect policymakers to soon target monetary and fiscal stimulus directly at the corporate sector. To this point, however, the Fed has targeted the Treasury market and mortgage-backed securities to improve liquidity conditions in the highest quality part of the US bond market. And we expect a broad-based fiscal package (tax cuts, government spending and more) that is many multiples of what has been announced so far.

As to the virus news flow and economic and corporate earnings data points, the environment is changing radically by the minute. In the US (as well as many other countries), we are rapidly adopting social distancing and other policies that are so important to flattening the virus curve. These are clearly the right policies, but they will have a more dramatic negative effect on economic activity and corporate earnings than most imagined even a week ago. Risk asset prices are declining as a result but we believe that—say, one year out—economic activity and corporate earnings will likely benefit from these policies, and so will high yield bond prices.

Again, we believe in the adage that there is a time to focus more on making money and a time to focus more on not losing money—in an environment like this (extreme volatility, concerns around liquidity), we focus on the latter for our clients. But we are making progress on the factors that should lead to attractive returns for long-term investors in the high yield market.

This material is for informational purposes and is prepared by Diamond Hill Capital Management. The opinions expressed are as of the date of publication and are subject to change. These opinions are not intended to be a forecast of future events, the guarantee of future results or investment advice. Reliance upon this information is in the sole discretion of the reader. Investing involves risk, including the possible loss of principal.

The ICE BofA U.S. High Yield Index tracks the performance of the U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. The index data referenced herein is the property of ICE Data Indices, LLC, its affiliates (“ICE Data”) and/or its third party suppliers and has been licensed for use by Diamond Hill Capital Management, Inc. ICE Data and its third party suppliers accept no liability in connection with its use.

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