Don’t Skip the Homework: High Yield’s Overlooked Risks

Many investors have taken on more risk in their quest for higher returns—especially as signs have pointed to interest rates staying stable until next year. But two key elements are often overlooked: default risk and underwriting standards.

The prolonged low interest-rate environment has continued to drive more investors toward high-yield securities. But all too often, they focus on interest rate risk, even though the high-yield sector has been fairly insulated from rising interest rates historically. Yield spreads—the extra yield above similar-maturity government bonds—often decline as rates rise, providing a cushion against rate increases. Lower-rated bonds, such as CCC-rated debt, usually have the most cushion because their spreads are higher.

An Unsettling Complacency

Today’s low overall level of high-yield spreads means this insulation is getting thinner and high-yield’s interest-rate sensitivity is increasing. Still, it’s far lower than that of investment-grade bonds, and any losses due to rising rates are generally offset rather quickly by the passage of time asinvestors collect coupons, and as bonds roll down the yield curve.

The spread cushion in high-yield bonds has obviously drawn in investors worried about rising rates. But what’s being missed is that the spreads are compensation for the likelihood of default—and the market has begun to feel complacent about this credit-related risk. In our view, it’s important that investors focus on bond default risk and high-yield issuers’ underwriting quality in order to prepare for the next phase of the credit cycle.

Monitoring Default Risk

As we’ve mentioned before , myopically chasing yield can be a dangerous game. We still believe that it will be at least a couple of years before we’re in the phase of the credit cycle when bond defaults are a serious concern. But investors shouldn’t disregard this risk just because default rates remain low. Companies have defaulted in the past year, and the lower the credit quality, the greater the probability of default.

There are warning signs to watch for. Price declines have always preceded the default phase of the credit cycle by a considerable amount of time, and we’re beginning to see issuer-specific events occurring. These are a telltale sign of the coming shift in the credit cycle. For example, a major retailer recently saw its bond price fall by 15%, and its outlook for recovery doesn’t look positive.

Looser Underwriting Standards

As underwriting standards diminish and poor-quality junk bond issues surface, an increasing number of investors are putting money into questionable securities. And even for creditworthy issuers, there’s reason for concern. According to Moody’s Investors Service, North American high-yield bonds reached an all-time low in covenant quality in February, which means there were fewer—and weaker—contractual safeguards to protect investors’ interests.

In her recent testimony before the US Congress, US Federal Reserve Chair Janet Yellen mentioned the loosening underwriting standards for high-yield bonds. Declining standards are a greater worry in the bank-loan market, but high-yield bonds aren’t exempt. And that means investors need to be selective.

Break Out the Books: Homework Is Key

Despite the current stable interest-rate environment and low default rates, we think it’s wise for high-yield investors to do their homework and research potential issuers carefully instead of simply jumping into high-yield bonds. Disciplined credit selection is more important than ever—arguably more important than investors’ focus on interest-rate risk—and in-depth research will determine success or failure for high-yield portfolios when the cycle turns.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Gershon M. Distenfeld, CFA

Director—High Yield
Gershon M. Distenfeld is Senior Vice President and Director of High Yield, responsible for all of AllianceBernstein’s US High Yield, European High Yield, Low Volatility High Yield, Flexible Credit and Leveraged Loans strategies. He also serves on the Global Credit, Canadian and Absolute Return fixed-income portfolio-management teams, and is a senior member of the Credit Research Review Committee. Additionally, Distenfeld co-manages the High Income Fund and two of the firm’s Luxembourg-domiciled funds designed for non-US investors, the Global High Yield and American Income Portfolios. He has authored a number of published papers and initiated many blog posts, including “High Yield Won’t Bubble Over,” one of the firm’s most-read blogs. Distenfeld joined the firm in 1998 as a fixed-income business analyst. He served as a high-yield trader from 1999 to 2002 and as a high-yield portfolio manager from 2002 until 2006, when he was named to his current role. Distenfeld began his career as an operations analyst supporting Emerging Markets Debt at Lehman Brothers. He holds a BS in finance from the Sy Syms School of Business at Yeshiva University and is a CFA charterholder. Location: New York

Ivan Rudolph-Shabinsky, CFA

Portfolio Manager—Credit
Ivan Rudolph-Shabinsky is a Portfolio Manager on the Credit team and leads the Low Volatility High Yield Portfolio Management team. He joined the firm in 1992 as a Portfolio Manager, and has held several posts, including head of the Product Development team; head of Product Management; and senior portfolio manager for the Stable Value, Inflation-Linked Bond, Canadian Fixed Income and Global Fixed Income teams. Rudolph-Shabinsky is the author of “Beyond Interest Rate Anticipation: Strategies for Adding Value in Fixed Income” and co-author of “Assigning a Duration to Inflation-Protected Bonds,” both published in Financial Analysts Journal. He also co-wrote both “Managed Synthetics,” published in The Handbook of Stable Value Investments, and “LDI: Reducing Downside Risk with Global Bonds,” published in The Journal of Investing. Rudolph-Shabinsky holds a BA in economics and Soviet/East European studies from Cornell University and an MBA from Columbia University. He is a CFA charterholder. Location: New York

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