In our last post from March, we recommended a slightly defensive risk posture for high-yield investors, with a focus on individual security selection. In our view, today’s high-yield bond market requires a carefully balanced approach. We remain selective with a modestly defensive risk tilt given rich valuations, while recognizing that low spreads may last longer thanks to ongoing monetary and fiscal support. We will watch for signs of central banks tightening or deteriorating liquidity before turning more defensive.
Macro environment: Positive
- At the time of writing, short-term economic data and corporate earnings are as good as it gets, thanks to the stimulus. We expect a modest slowdown into the second half of 2021.
- Inflationary pressures are building across both emerging markets (EM) and developed markets (DM), with price rises potentially spilling over from goods into services. Policymakers view these pressures as a transitory phenomenon, but we will monitor to determine whether they prove more enduring.
- We are concerned about these dynamics and, broadly speaking, would caution investors to keep duration below that of the high-yield benchmarks.
- Global liquidity, while still abundant, has peaked. We will scrutinize liquidity conditions for signs that could lead to increased market volatility.
- The upturn in the commodity cycle may help some EM economies. We note select instances of tightening, notably rate hikes in Brazil and Russia and Chinese regulators’ renewed focus on deleveraging and suppressing speculation.
Corporate fundamentals: Neutral
- The quality of new issuance is deteriorating as investors hunt for yield, while the rise in stock buybacks and capex announcements suggests that companies have begun to prioritize shareholders over bondholders.
- Defaults remain very low and have continued to decline recently.
Market valuations: Negative
- With spreads now below pre-pandemic levels, total returns are likely to be more dependent on the direction of government bond yields.
- Credit selection is more key than ever, given the lack of differentiation. Valuations of leveraged loans and bonds have largely converged and spread compression is acute, even in the low-quality CCC-rated segment of the market (Figure 1).