Following another sell off, the US high yield market has once again touched the psychologically important 8% yield level today. This is an important valuation signal that has helped to tempt investors back into the market in recent months. However, the last move up in yields has been driven in part by a renewed downdraft in commodity prices, not least with WTI pricing in the low $40’s. Energy issuers make up a not insignificant 12.7% of the US high yield market so such moves cannot be easily shrugged off. Hence, the most common rejoinder to any assertion that “US high yield is cheap” when yields hit these levels, is that it’s “cheap for a reason”.
Is there a way around this? Can investors benefit from headline yields in the high single digits without taking on the heightened commodity risk of buying the bonds of financially levered oil and gas producers?
Well the short answer is “kind of”. You can benefit from high single digit yields, but not without some compromise. Here are 4 potential ways to do it:
- Go “Commodity Free” – This would be a portfolio that excludes both the Energy, Steel and the Metals & Mining sectors (as defined by BofA Merrill Lynch), which together account for 17.5% of the market, but holds a proportionately equally weighted amount of whatever remains. The all in yield for such a portfolio would be roughly 6.8% with the 2 largest sectors being Banking and Telecommunications.
- Go “Commodity Lite” – How about a portfolio that gave you a 50% weighting to the Energy, Steel and the Metals & Mining sectors (i.e. a more manageable 8.7% combined weighting)? This would produce a yield of 7.5% today – a comparatively smaller give-up to the 8.0% market head line yield. This would probably suit investors who feel that a lot is already priced into credit spreads in the commodity related sectors.
|Yield||% of US HY Market|
|US High Yield||8.0%||100%|
|US High Yield Energy||12.3%||12.7%|
|US High Yield Steel||10.8%||1.6%|
|US High Yield Metals & Mining||14.8%||3.2%|
Source: BofA Merrill Lynch, Bloomberg
- Leverage up – if the 8% yield target is sacrosanct, this can be achieved by using a moderate amount of leverage on a “Commodity Free” US High Yield portfolio. A gross exposure of 116% would be required to make up the yield shortfall (before taking into account the cost of any funding). A “Commodity Lite” portfolio would require a more manageable 106% gross exposure. However, for good reason, many investors are unable or unwilling to employ leverage in their portfolios (including us).
- Use Longer Dated Bonds – if capturing the potential upside from tighter spreads (and the associated capital gain) was the priority, one way to keep pace with a market rally but without commodity exposure would be to buy a longer dated non commodity portfolio. The US high yield market has a credit spread duration of 4.1 years (i.e. for every 100bps of spread move, there is roughly a 4.1% capital impact). When we adjust for differences in spread levels between sectors, we think a “Commodity Free” portfolio with 4.9 years of credit spread duration would capture the same upside assuming a proportional move in credit spreads across the market. The same number for a “Commodity Lite” portfolio would be 4.4 years. The downside here is that spread duration is difficult to separate from interest rate duration and hence there would also be more exposure to moves in the treasury yield curve with this strategy.
As is so often the case, there is no free lunch here – if investors want the 8% yields on offer, they have to be exposed to the more volatile sectors and take on associated default risks. Nevertheless, as we can see from the above, there are several ways in which relatively attractive yields can be achieved whilst minimising some of the underlying commodity risk.