February 23, 2018
Positive fundamental factors underlying the corporate sector continue to underscore our constructive stance on high-yield corporate credit as we enter what our macroeconomic team believes to be the penultimate year before a recession. Average leverage ratios and interest coverage ratios improved in 2017 on the back of strong earnings growth. As fundamentals improved, the 12-month par-weighted trailing default rate in the Bank of America Merrill Lynch High-Yield index fell to just 1.65 percent by year end, compared to a historical average default rate of 4.15 percent. We believe credit risk should remain benign in 2018.
Average leverage ratios and interest coverage ratios improved in 2017 on the back of strong earnings growth. As fundamentals improved, the 12-month par-weighted trailing default rate in the Bank of America Merrill Lynch High-Yield index fell to just 1.65 percent by year end, compared to a historical average default rate of 4.15 percent.
Source: Bank of America Merrill Lynch, Guggenheim Investments. Data as of 12.31.2017.
High-yield corporate bonds lost steam in the fourth quarter, with the Bank of America Merrill Lynch High-Yield index delivering 0.4 percent total return with spreads wider by 5 basis points. High-yield spreads tightened by an average of 66 basis points in 2017. Total return for the year was consistent with our expectations of mostly earning coupon income plus some limited price upside. The high-yield corporate bond market returned 7.5 percent in 2017, with mixed returns by rating. BB-rated, B-rated, and CCC-rated bonds delivered 7.3 percent, 6.9 percent, and 9.3 percent total returns, respectively.
The reduction in the corporate tax rate from 35 percent to 21 percent could be the catalyst for further spread compression between high-yield and investment-grade corporate bonds, where the premium remains at the 2005–2007 average level and above historical lows.
Source: Bloomberg, Guggenheim Investments. Data as of 1.22.2018. Shaded areas represent periods of recession
Tax reform will be a key driver of performance for high-yield corporate bonds this year. The reduction in the corporate tax rate from 35 percent to 21 percent is expected to help boost cash flow primarily for smaller, domestically focused companies given that they typically pay the highest effective tax rates. This description generally applies to high-yield borrowers, especially BB-rated and B-rated companies. We believe this could be the catalyst for further spread compression between high-yield and investment-grade corporate bonds, where the premium remains at the 2005–2007 average level and above historical lows. We are concerned that the inability of borrowers to deduct interest expense above 30 percent of earnings before interest, taxes, depreciation, and amortization going forward will likely hurt many CCC-rated companies that already pay interest expense above this threshold. This change does not impact our strategy significantly, which has been focused on higher-quality borrowers for some time, but we believe it could spell trouble for 10–15 percent of the high-yield market. Investors should safeguard portfolios for a potential rise in CCC-issuer spread volatility by the end of the year.
—Thomas Hauser, Senior Managing Director; Rich de Wet, Director
This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.
Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. ©2018, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.
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