High-yield credit has had a nice run since 2009 as a primary beneficiary of the Fed's easy monetary policy, which has resulted in low volatility and low interest rates. Investor's ensuing search for yield led to an increased demand for riskier securities, resulting in billions of dollars of inflows into the asset class.
While I expect the credit cycle to last into 2017, weaker credit quality is becoming evident. This week's chart shows credit quality gradually deteriorating, particularly as you migrate down the credit spectrum. This trend will be further exacerbated by the weakness in the energy sector as hedges roll off next year.
Weaker credit stats in and of themselves are not a sufficient condition to trigger a sell-off. This is particularly true given that valuations (spread levels) are in line with 20-year median levels. A catalyst is needed, and while there are many potential candidates for a catalyst -- including Greece and China -- the beginning of the Fed tightening cycle is a likely source.
Historically, there has been a negative inverse relationship between interest rates and high-yield bonds, as higher rates imply stronger economic growth. Therefore, high-yield bonds absorb the higher interest rates more effectively in the beginning stages. Thus, high yield may still be a good relative performer as we exit the year.
However, things are likely to get more volatile as investors discount future rate hikes in 2016 and 2017 and the likelihood of higher default rates comes into focus. If returns suffer, outflows will ensue. Given the well-documented and anecdotal evidence of poor liquidity in the high-yield market, elevated outflows will cause further underperformance, which could further exacerbate a negative feedback loop.
Key Takeaway: For strategists that are constructive on high yield as the first interest rate hike approaches, many advocate a down in quality emphasis (single B weighted), as opposed to the more duration-sensitive lower coupon BB rated bonds. This may be dangerous given creeping credit deterioration (leverage and profitability), the late-stage nature of this cycle, and poor market liquidity. Instead, I would advocate an up in quality bias, and look to add BB rated credit on sustained weakness. Repositioning a portfolio in anticipation of a potential turn in the cycle is difficult, as it could mean foregoing performance in the interim, but it may pay off down the road as defaults accelerate.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.
High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
All trademarks are the property of their respective owners. This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission.
