via Almost Daily Grant
Junk has been the place to be for credit investors, as the Bloomberg Barclays High Yield Index has delivered an 8.3% total return year-to-date, topping the 7.1% gain in the iBoxx Liquid Investment Grade Index and outpacing the 5.7% generated by the S&P/LSTA Leveraged Loan Index. Even after a recent pullback in prices, the ICE BAML High Yield option-adjusted spread sits at just 403 basis points over Treasurys, well below the 552 basis point average going back to 1997.
What’s driving the superior performance in high-yield? The prospect of an easier Fed is one key contributor, helping increase the perceived value of fixed-rate junk bonds as opposed to floating-rate loans. Relatively robust economic growth (GDP growth has averaged an annualized 3.3% over the last four quarters) has likewise helped, as has a buoyant stock market. Meanwhile, defaults have remained low, with Fitch Ratings forecasting that May’s trailing 12-month high-yield default rate will settle at 2%. That compares to 4.7% in calendar 2016 and 14% in 2009, per Fitch.
Some investors expect the good times to continue. Vivek Bommi, senior portfolio manager at Neuberger Berman, told Bloomberg over the weekend that the junk bond market “is very attractive, given that the fundamentals are still very good and corporate credit quality is still good.” Bommi notes that the post-crisis boom in leveraged loan issuance has shifted risks away from high-yield: “In the last 10 years, a lot of the more aggressive issuance that may have gone into the high-yield market has gone into other markets like private credit or loans.”
But with the economic expansion set to match the post-World War II record of 110 months in June and the stock market still less than 5% below its closing high-water mark, some concerning signs have emerged. Economic growth looks set to slow, as the Atlanta Fed’s GDPNow tracker indicates second quarter output growth at just 1.2%, revised down from 1.6% on May 14. Retail sales for April fell by 0.2% on a sequential basis, vs. expectations of a 0.2% gain. Resource prices likewise look to be rolling over, with the Goldman Sachs Commodity Index down 5% over the last month.
Broad cracks in credit are also appearing. On Monday, the Financial Times published an analysis showing that non-performing loans among the 10 largest commercial lenders in the U.S. jumped by 20% sequentially in the first quarter, snapping a streak of improvement in that metric dating back to 2016. Brian Foran, a bank analyst at Autonomous Research, tells the FT that unlike three years ago, when plunging oil prices pushed a number of energy-related borrowers into distress, the recent uptick is broad-based: “There hasn’t been a clear theme.” Meanwhile, rich valuations leave little room for error. Marty Fridson, chief investment officer of Lehmann, Livian, Fridson Advisors, LLC, writes in S&P Global’s LCD publication that his fair value estimate of the ICE BAML option adjusted spread is 648 basis points, far above the 405 currently on offer. “That qualifies as an extreme overvaluation even if one interprets the Fed’s more recent retreat from its strongly stated intention to tighten rates as an effective reinstitution of quantitative easing.” Reached by Grant’s this afternoon, Fridson added that even supposing a new round of QE, high-yield is overvalued by more than 100 basis points by his analysis .