UBS: Do rewards outweigh the risks in high yield debt?

Government debt securities in developed countries now offer investors slim pickings. Nearly 40% trade at zero or negative yields, offering investors scant income and even a capital loss if bought today and held to maturity. Equities have not benefited, however, in the hunt for favorable risk-adjusted returns. Investors pulled around USD 90bn out of global stock funds year-to-date, the fastest pace of redemptions since 2011.

There is no question that spreads are attractive. US HY now trades at roughly 626 basis points (bps) above Treasuries, higher than the median of 510bps over the past two decades. Euro HY, meanwhile, offers a 472bps yield premium over sovereigns, about a third higher than five-year lows seen in 2014. Overall, high yield bond yields are attractive, particularly against higher quality bonds, with US HY offering a yield of 7.9% and Euro HY 4.8%.

But US companies are far more advanced in the credit cycle than Eurozone counterparts. Leverage has steadily increased in recent quarters, with issuance to fund corporate acquisitions rising. This leaves balance sheets vulnerable at a time of declining growth of corporate profits, which softened in late 2015 through 1Q 2016. We expect US earnings to recover in the second half of 2016, but the HY market’s net debt to earnings before interest, tax, depreciation, and amortization (EBITDA) ratio looks elevated. At 4.8 times in the last quarter of 2015 (ex-commodities), this measure stands above the average of 4x seen since 1998.

US lending standards also tightened for a third consecutive quarter in 1Q 2016, according to the Fed’s Senior Loan Officers’ Survey. This trend could spur a rise in defaults (which CIO expects), from 4% today on a trailing 12-month basis towards 4–5% over the coming 12 months. Weighing return potential against risks, we are neutral on US HY in global portfolios at this stage. 

By contrast, European firms have been far more cautious in taking on debt, leaving balance sheets in far better shape. Debt-to-earnings levels stand at about 3x, close to the post-crisis low of 2.5x.

Companies should find it even easier to access further financing in the Eurozone. The European Central Bank’s (ECB) 1Q 2016 Bank Lending Survey indicated a net 6% of banks eased standards on loans to businesses, above the average since 2003. Central bank easing has helped lower borrowing costs, and the ECB’s decision to expand its quantitative easing purchases to investment grade corporate bonds could push investors out the risk curve, also boosting demand for HY bonds.

With default rates expected to rise only slightly over the coming 12 months to around 2%, and lower exposure to oil-price sensitive energy issuers (6% in the Euro Index versus 17% in the US), the risk-return profile of Eurozone HY still looks attractive. CIO is overweight on Euro HY in global portfolios. Investors question liquidity in HY markets. Dealer inventories have fallen in the post-financial crisis world of stricter bank regulation. However, secondary bid-ask spreads in the US market of 1.04 price points are in line with the five-year average of 1.03, and for Euro HY, the current 1.31 spread is only around 15% higher than average. Investors should prudently consider a well-diversified portfolio of HY debt to avoid company-specific risks. However, we think that liquidity concerns do not outweigh potential HY rewards, especially in the euro market.

Authors: Matthew Carter and Carolina Corvalan
UBS Global Investment Office

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