Stockholm (Ekonamik) – The final quarter of last year may have been brutal for high-yield bonds, but junk has become a much sought-after asset class among investors since the start of the year. With credit spreads having tightened at a fast pace, should investors anticipate an end to the high-yield rally? – While strong fundamentals reassure some asset managers others find the market overvalued.
The Bloomberg Barclays US Corporate High Yield Index delivered a total return of 8% year-to-date, whereas the Bloomberg Barclays Pan-European High Yield Index generated a gain of 5.8% over the same period. Despite the pullback in prices thus far in May, the ICE BofBAML US High Yield option-adjusted spread, which reflects the high-yield bond spread relative to comparable-maturity U.S. Treasuries, stands at 422 bps. This is well below the average spread of 552 bps going back to 1997. The valuations of European high-yield are not too far away, as the European high-yield spread sits at 397 bps as of May 22.
Where do high-yield markets go from here?
Given the recent spread tightening, it is worth wondering what’s in store for high-yield markets going forward. Some investors still expect good times ahead for high-yield, whereas others believe current valuations leave little margin for error. Mikael Lundström, CIO at Finnish fund management boutique Evli, wrote earlier this month that “the rally this year has been even stronger than expected,” adding that “we do not expect it to continue at such a torrid pace but there is still room for spreads to tighten.”
Lundström argues that current European high-yield spreads are not too far off from the spread levels seen throughout 2016 and 2017, saying that “it has paid to stay invested” in high-yield bonds despite their seemingly rich valuations a few years ago. “The high-yield market has boasted cumulative returns of over 15%” in the past three years. Speaking of the European market, Lundström argues that the fundamentals of high-yield issuers “are still robust,” further adding that “European default rates are very low, and we expect them to stay there.”
On the other side of the pond, some investors corroborate Lundström’s views. Vivek Bommi, senior portfolio manager at Neuberger Berman, recently told Bloomberg that the high-yield market “is very attractive, given that the fundamentals are still very good and corporate credit quality is still good.” Bommi argued that the high-yield market has become less risky over the past decade. “In the last ten years, a lot of the more aggressive issuance that may have gone into the high-yield market has gone into other markets like private credit or loans,” Bommi told Bloomberg. “The market itself has gotten much more healthy.”
Historically, the high-yield credit market has proven to be quite sensitive to business and economic cycles and corporate fundamentals. As Petter von Bonsdorff, Head of International Business Development for Evli’s funds, told hedge fund platform HedgeNordic in the second part of last year, “deteriorating company fundamentals are the root of defaults.” Yet, David Mihalick, Head of U.S. High Yield Investments at Barings, reckons that “fundamentals were not to blame for the volatility” in high-yield credit markets in the final quarter of 2018. In April of this year, Mihalick said that “while investor sentiment was swinging from one extreme to the other, the companies in the high yield universe were quietly ticking along and, we know now, actually wrapping up a strong quarter from an earnings perspective.”
According to Mihalick, around 75-80% of a universe of 400 high yield issuers that are listed on public equity markets met or exceeded earnings expectations in the fourth quarter. Explaining the heightened volatility in the fourth quarter, Mihalick said that “it was largely technicals—particularly retail outflows— that created the short-term instability, which drove asset prices lower and created a good buying opportunity for us at the end of 2018.”
Northern Trust shares in this market optimism “High Yield flaunted a 6% return through 1Q19 – demonstrating the best start to the year since 2001,” according to Ian Birtch, Fixed Income Portfoilo manager, and Arch King, Fixed Income Specialist, at the end of April.”Portfolios are positioned in the mid-range of the credit quality spectrum. Issuer selection is of utmost importance as we have few sector overweights outside of banks and energy,” they advise. “The ratio of CCC spreads to BB spreads is near its widest level since the end of 2016, during the commodity crisis. The backdrop for high yield remains strong as default rates remain low and interest coverage ratios remain high. Additionally, issuance is expected to remain low for the remainder of 2019.”
Are high-yield credit markets priced for perfection?
Although fundamentals continue to hold up reasonably well, some investors believe current valuations might have become too stretched. Marty Fridson, CIO of Lehmann Livian Fridson Advisors, wrote in S&P Global’s Leveraged Commentary & Data publication that his fair value estimate of the ICE BAML option-adjusted spread is 648 bps, markedly above the current spread of around 400 bps. “That qualifies as an extreme overvaluation even if one interprets the Fed’s more recent retreat from its strongly stated intention to tighten rates as an effective reinstitution of quantitative easing.”
With current interest rates still by historical standards, yield-seeking investors may continue channelling capital into high-yield credit markets, triggering a rise in prices and a reduction in yields further below historical averages. Yet, the macro-political and economic environments are deteriorating, partly because of the deepening trade war between the U.S. and China. For that reason, high-yield credit markets could still be vulnerable in such periods of high uncertainty. Given the market’s sensitivity to broader risk sentiment, positive catalysts might trigger risk-on moves too.
As Chris Iggo, CIO for Fixed Income at AXA Investment Managers, wrote in mid-May, “if there is going to be a market wobble this summer, then it will be the higher beta parts of the market that suffer – high yield and emerging market debt.” Should that happen and should there be “confidence that any weakening of global growth is a transitory one – then the strategy will be again to load up on credit.” This strategy “worked in 2016, it worked in January of this year and it will work again. But now, spreads are too tight to add,” concluded Iggo.
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