Along with risk assets across the board, the high yield market is currently undergoing a dislocation the magnitude of which occurs only once every decade. Uniquely for high yield credit, returns can be scenario-tested based on discrete cash flows because either coupons and principal are paid or bonds default and creditors recover on the claims. GMO has developed a stress test for the high yield market that demonstrates that while the bottom may not yet be in sight, the sell-off is being overdone given the high yield market can deliver positive real returns through a cycle even under draconian default and loss assumptions. Accordingly, there is shelter in credit. Meanwhile, if heightened volatility subsides, we believe high yield bonds are priced to deliver substantial total returns. Security selection can add incremental alpha as the good is abandoned indiscriminately with the bad and the ugly as people distance themselves from risk. If history once again rhymes, then we believe the return profile for high yield to prove superior to equities post this historic drawdown.
High Yield Market’s Wild Ride
The rapid seizing up of global markets has brought into play a new Minsky moment. No longer taking cues from Chuck Prince,1 the markets’ music has halted2 abruptly once again, perhaps this time fueled by Lil Nas X’s absurdist chart topping 2019 single “Old Town Road” which defiantly proclaimed: “Yeah, I'm gonna take my horse to the old town road. / I'm gonna ride 'til I can't no more.” What seemed like an easy ride just months ago has become a bucking bronco, forcing investors, companies, consumers, and policymakers to make challenging decisions in a time of extreme uncertainty. Investors, who spent the past few decades loading up on illiquid assets (private credit, private equity), are now in a mad dash for liquidity all at once.
A scan of valuations in credit markets following the extreme price action of the past month and a half offers some chart-topping data points:
- The high yield spread has topped 1,000 bps, its widest level since 2009.3
- High yield through March 20 has registered a -17.5% return, which thus far is the worst month ever recorded (September 2008 registered a -16.3% return).4
- The trading week ending March 20 registered record outflows of $108.9 billion out of bonds (Monday, March 16 was the largest daily outflow ever at $30.2 billion) while inflows to cash surged to $95.7 billion (fourth largest week ever).5
While this would suggest an attractive entry point, we must also consider the potential downsides and that asset prices might sell off further:
- The current high yield spread of 1,000 bps compares to ultimate wides of over 1,100 bps in 2002 and 2,000 in 2008.6
- High yield drawdown was 33% from June through November of 2008.7
In situations of great uncertainty, it is helpful to run scenario analysis. The extent of the unknowns that the Covid-19 pandemic and corresponding policy actions present makes this more challenging than ever. The amplitude and duration of this crisis and all knock-on effects are unknown. On the downside, it is plausible that the tail risk may match or exceed the market stress experienced in the Global Financial Crisis of 2008-2009. On the upside, it is plausible that aggressive actions on virus containment, human resilience, innovation, and fiscal and monetary policy support can level off the spread of the virus and social and economic life can begin to recover within a reasonable timeframe. For financial markets, the scenarios are vague with so much noise and so little signal, so much data but so little predictive capacity, that perhaps the dash for cash is instructed by the chorus from “Old Town Road”: “Can’t nobody tell me nothing.”