March 2018 | Christopher Jones, CFA, Fixed Income Portfolio Manager
The current global macro environment appears supportive for high-yield bonds. Some of the indicators that I have found useful over time include: the global purchasing managers data, which is strong; leading economic indicators, which are pushing higher; and the US Federal Reserve (Fed) and European Central Bank (ECB) loan officer surveys, which are pointing toward a further decline in corporate defaults.
However, in my view, there are a few pieces of data that are raising some questions, and potentially concerns, looking to 2019. The impact of a reversal of quantitative easing is a big unknown. Quantitative tightening could have a negative impact on global equity returns. High-yield bonds would likely be softer as well. The US Treasury yield curve is another indicator that we watch — and while it is neither steep nor flat currently, there is reason to believe that it could continue to flatten, which generally has been a recessionary signal. Finally, the recent VIX spike is disconcerting: The initial spike seems explainable as just a technical response to a massive levered unwind, and, as of this writing, it does seem to be gradually coming back down. But should it stay elevated, I think we should pay attention because current spreads and the VIX have diverged rather meaningfully.
I would characterize company fundamentals as fairly strong. Global defaults are low at 3.1%1 and our data points toward something close to 2.0% in the next nine months. Interest coverage (or issuers’ ability to pay coupons) has remained relatively stable over the past few years due to both expanding margins and reduced interest rates offset by a continuing increase in debt. There is a concern here, however, that average interest rates have stabilized and are likely to move higher as the Fed raises rates. Profit margins also could begin to come under pressure if wages or other input costs begin to rise. It’s too early in my view to be too concerned about this, but it is something to watch. I’d also note that through a combination of underwriter regulations and fear retaining the upper hand over greed post-financial crisis, that high-yield deal quality has remained relatively strong.
The long-term technical picture is still positive, in my opinion. As the developed world ages, the demand for income continues to be robust. And with global rates as low as they are, high yield remains one of the few places to find yield. Technicals continue to be surprisingly strong even with increased volatility and a steady stream of mutual fund outflows. However, the cost for European and Japanese investors to hedge US-dollar denominated assets back to their home currency is something that I’m watching from a nearer-term technical perspective.
As of the end of February, high-yield spreads were in the twenty-second percentile, meaning spreads have only been tighter 22% of the time throughout history.2 At today’s spread of +336 basis points, we’re about 20 basis points wide of post-global financial crisis (GFC) tights and about 115 basis points wide to all-time tights. As long as the fundamentals remain strong this year, I think we could tighten at least back to the post-GFC tights and maybe into the high 200s. However, should rates continue to rise as I expect, tightening will likely occur due to rates moving up toward yields rather than yields moving down toward rates. In other words, I believe income levels should remain good, but capital appreciation will likely be more limited from here.
In terms of relative value, I prefer US high yield to either euro or emerging markets high yield right now, mostly due to valuation. I also think bank loans are interesting relative to high-yield bonds, particularly as short rates rise. My view is that high-yield bonds will likely outperform loans by a small margin this year, but that the risk-adjusted return of loans may be better. I generally prefer single-B-rated credits to double-Bs — both because of relative rate sensitivity and valuation.
Finally, I believe that this year, like last year, is going to be about idiosyncratic risk. Many investors will win or lose based on the credits they pick, more than based on overall risk position.
1 Source: Moody’s, as of February 2018. | 2 Source: Bloomberg Barclays, as of 28 February 2018.
Views expressed are those of the authors. Views are as of 28 February 2018, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This piece contains estimates and forecasts. Actual results may differ, perhaps significantly, from the estimated and forecast data shown. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities.
Investors should consider the risk that may impact their capital, before investing. The value of your investment may become worth more or less than at the time of the original investment. Please refer to the risk section at the end of this document.
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