High-yield investors bracing for a downturn in 2018 can relax. By some metrics, high-yield companies have rarely looked better. The way we see it, investors who do their homework can still profit in this environment.
After a strong 2017, high-yield bonds have struggled this year as US Treasury yields spiked and inflation potential stirred up fears that the Federal Reserve may raise borrowing costs more aggressively. With the US credit cycle in its 10th year and credit spreads—the extra yield high-yield bonds offer over comparable government debt—near record lows, some investors are no doubt asking themselves whether high yield’s potential return is worth the risk.
The answer, as far as we’re concerned, is yes. What makes us so sure? Simply this: in high yield, there are three warning signs that usually precede trouble—and none of them are flashing red yet. Let’s take a closer look.
Warning Sign No. 1: When Leverage Ratios Are High and Rising
Financial leverage is a lot like the water in a major river: when it’s high and rising, we start to worry—especially if we’re late in the credit cycle. But over the past few years, leverage has been declining in the high-yield market, leaving it less vulnerable to today’s rising-rate and late-cycle environment.
Energy companies are one reason for this. Many went on a borrowing binge earlier in the decade when commodity prices were high. Since the collapse of prices in 2014 and 2015, leverage in the sector has come down sharply. But leverage has been remarkably stable in the rest of the market too. This is partly because strong corporate earnings have vastly increased cash flow. But even after a 10% increase in EBITDA growth in 2017, companies simply haven’t been stretching to make large capital expenditures or buy back stocks (Display 1).
In the US, many companies may be concluding that now isn’t the time to ramp up leverage. Yes, solid economic growth has been a boon for many issuers. And comprehensive US tax reform is likely to boost earnings this year. But after that, most companies expect the rate of earnings growth to slow and appear to be acting responsibly.
In Europe, leverage ratios are down, too, largely the result of stronger eurozone growth and improving corporate fundamentals.