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 and Investment-Grade Credit
Gershon M. Distenfeld is Senior Vice President and Director of High Yield and Investment-Grade Credit at AB, responsible for overseeing the investment strategy and management of all investment-grade and high-yield corporate bond portfolios and associated portfolio-management teams. Strategies under his purview span the credit and risk spectrum, from short-duration investment-grade corporate bond portfolios to regional and global high-yield portfolios, encompassing a range of investment approaches, objectives and alpha targets, from income-oriented buy-and-hold strategies to active multi-sector total return strategies, and including both publicly traded securities and private placements in developed and emerging markets. Distenfeld also co-manages AB’s award-winning High Income Fund, recently named “Best Fund over 10 Years” by Lipper from 2012 to 2015, and the award-winning Global High Yield and American Income portfolios, flagship fixed-income funds on the firm’s Luxembourg-domiciled fund platform for non-US investors. He also designed and is one of the lead portfolio managers for AB’s Multi-Sector Credit Strategy, which invests across investment-grade and high-yield credit sectors globally. Distenfeld is the author of a number of published papers, including one on high-yield bonds being attractive substitutes for equities and another on the often-misunderstood differences between high-yield bonds and loans. His blog “High Yield Won’t Bubble Over” (January 2013) is one of AB’s all-time most-read blogs. Distenfeld joined AB in 1998 as a fixed-income business analyst, and served as a high-yield trader (1999–2002) and high-yield portfolio manager (2002–2006) before being named Director of High Yield in 2006. He began his career as an operations analyst supporting Emerging Markets Debt at Lehman Brothers. Distenfeld 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 Senior Vice President and Credit Portfolio Manager, focusing primarily on the Low Volatility High Yield Strategy and the Short Duration High Yield Fund on the Luxembourg-domiciled fund platform, designed for non-US investors. He is a member of the Credit and High Yield fixed-income portfolio-management teams, and a member of the internal Credit Research Review Committee, the primary investment policy and decision-making committee for all AB’s credit-related portfolios. Rudolph-Shabinsky joined the firm in 1992 as a portfolio manager, and managed the Stable Value and Inflation-Linked Bond strategies. He has held other leadership posts at the firm, including head of Product Development and head of Product Management. Rudolph-Shabinsky has also authored or co-authored a number of papers, including “Beyond Interest Rate Anticipation: Strategies for Adding Value in Fixed Income” (2000) and “Assigning a Duration to Inflation-Protected Bonds” (1999), both published in the Financial Analysts Journal. He also co-wrote “Managed Synthetics,” published in The Handbook of Stable Value Investments (1998), and “LDI: Reducing Downside Risk with Global Bonds” (2012), published in The Journal of Investing. Rudolph-Shabinsky has written many blogs highlighting the risks in bank loans and in high-yield CCC-rated bonds. He holds a BA in economics and Soviet/East European studies from Cornell University and an MBA from Columbia University, and is a CFA charterholder. Location: New York

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