What Happened to High Yield?

December 17, 2015

The recent sell-off in the U.S. high yield market has caused concern among investors and many worry that the situation will worsen before improving; this is especially concerning because of its effects on portfolio values before calendar year-end. The Credit Suisse High Yield Index returned -1.08% on Friday, December 11th and recorded another down day when the markets reopened on Monday with a return of -1.39%. Through December 14th, high yield has dropped 4.15% for the month and 6.11% for the year. As of December 14th, the yield for the index is 9.42% and the spread is 774bp.

The declines reflect liquidity concerns in the high yield market after the closure of a junk-bond mutual fund. Many investors took advantage of low bond prices after the financial crisis, betting that the U.S. economy would recover. While that thesis proved to be a profitable one, there has been a gradual change in sentiment, with significant outflows in high yield mutual funds over the last three years, including $10.5 billion this year. So what is driving this liquidity concern and subsequent sell-off?

Many would argue that the prolonged period of low oil and other commodity prices are the primary drivers of the sell-off, and are expected to drive default rates higher for the energy portion of the high yield index. As shown in the chart above, energy and metals/minerals constitute roughly 18% of the index. With commodity prices struggling and OPEC not willing to slow production in oil, the fear is that the underlying prices will continue to fall. A further fall in prices — particularly in the energy and metals/minerals industries — will lead to greater revenue losses and a higher likelihood of defaults. Although default rates for the other sectors of the index are expected to remain close to their long-term averages, high yield funds with a significant overweight to the energy and metals/minerals sectors may suffer above average losses over the coming year.