Tighter spreads, higher interest rates put asset class on back burner
Money management executives and consultants are starting to fall out of love with high-yield bonds following a tumultuous but rewarding 2016, as the outlook wanes for the asset class amid rising U.S. interest rates.
Some sources now are saying they are making tactical shifts away from the asset class and prefer the floating-rate characteristics of bank loans.
High yield was rallying for much 2016 following a dismal period that extended into the first quarter driven in part by difficulties in the oil and energy markets. The asset class was on the buy list for money managers and consultants, and those invested were rewarded with impressive returns. The Bank of America/Merrill Lynch Global High Yield index gained 14.77% in 2016, compared with a 4.17% loss in 2015.
But now alarm bells are ringing for some, with rising U.S. interest rates and tightening spreads given as reasons for caution. Others said the asset class has become a victim of its own success.
“While we continue to have high-yield managers on our recommended list since high yield is a long-term asset allocation decision, we have recommended a tactical shift away from high yield” in the past couple of weeks, said Tim Bruce, Boston-based director of traditional research and a partner at consultant NEPC LLC. “The reason for that in part is because index-aware high-yield strategies enjoyed exceptional returns in 2016. Outsized credit spreads fell to historic median levels as the energy market and economic outlook improved in 2016.”
Also, the “extended U.S. economic growth cycle supports positive returns and can push credit spreads below long-term levels. Credit markets continue to benefit from high demand in a low-rate environment, but current spread levels are less compelling,” said Mr. Bruce.
The view is similar among European sources. Following rallies in 2016, consultant Mercer Investments was relatively positive on the asset class. But with spreads tightening, executives have downgraded high yield to “unattractive,” said Edward Krijgsman, principal at Mercer in Amstelveen, Netherlands. “The spread currently is, in our opinion, not enough to compensate for any default that may take place in the segment,” he said.
Timothy J. Atkinson, senior vice president at Meketa Investment Group in London, said return expectations are lower today than a year ago. “We are concerned with certain valuations. But that being said, (for) our clients we have a long-term allocation to high-yield bonds” with a target allocation. For discretionary clients, executives alter exposure based on current views. “We are not eliminating high-yield exposure, but we are slightly underweight in our portfolios,” Mr. Atkinson said. The firm has not taken all exposure off the table because of high yield's lower duration, higher carry, “and relative to other higher yielding asset classes, it is more liquid.”
BNP Paribas Investment Partners moved to underweight last month having already cut to a neutral position on the asset class previously. “This time last year we were looking more to buy high yield than sell it, which the crises around China and the oil industry in the U.S. intensified,” said Colin Graham, chief investment officer, head of active asset allocation, multiasset solutions at the firm in London. There was an opportunity at that point to buy the asset class, with “pretty much all” of BNP Paribas' scenarios giving a positive return.
However, through 2016 spreads “came in enormously in high yield,” and now, looking at expected returns for this year, “in two out of three scenarios we can see negative returns coming to high yield from the valuations,” he said. For that reason, the firm moved to underweight the asset class.
Continued low prices in oil markets was one of the problems weighing on high yield throughout 2016, and Mr. Graham said this is still a concern. Developments in technology, such as horizontal drilling for oil, could mean supply outstripping expectations. “We know that U.S. high yield is still reasonably exposed to oil and energy. If there is oversupply, we could get another bout of weakness in funding for oil projects through the high-yield market,” said Mr. Graham.
Executives at BlueBay Asset Management are less concerned about the oil market. A combination of coordination between oil producers “plus balance sheet repair and rationalization that has gone on in that sector does bode quite well,” said Marc Kemp, institutional portfolio manager at the firm in London.
Following a strong year for institutional inflows to high yield, he said BlueBay has not seen the conversation trail off.
But there is an elephant in the room: the U.S. “We're very conscious that we can paint a positive picture for U.S. corporates when we talk about U.S. reform and tax cuts (under the new administration), but deglobalization could have implications,” said Mr. Kemp. “We cannot just indiscriminately say it is going to be great for corporate America. For us, it is about picking the right sectors. It is important not to be blasé and say the market is going up — it is much more about a concentrated stock selection process for us.”
The continued European political cycle, with three major elections in the first half of the year, also poses a risk. “Individually, we are not overly perturbed. (The Italian referendum late last year) was the biggest hurdle for us, but we are conscious that history tells you (that) you cannot rest on your laurels. There is sufficient room in the polls in upcoming elections” to surprise, he said. However, executives do not see default rates increasing.
The other spanner in the works for high yield is the rising — albeit gradual — interest rate environment in the U.S. “We have turned a corner in interest rate policy in the U.S. — if anything the economy is stronger now than a year ago. In that environment, high yield will give you some protection against rising bond yields, but at these spreads it is likely to be minimal,” said BNP Paribas' Mr. Graham.
Some executives prefer bank loans to high yield in that situation. “Our recommendation is to make use of other credit strategies to capture pockets of value,” said Mr. Bruce. “Bank loans and short duration high yield offer higher expected returns than high yield due to limited duration exposure.
Meketa is moving toward its target weight on bank loans. “We are more positive on the fundamentals, and like the floating-rate nature of that asset class vs. the fixed-rate nature of high yield,” added Mr. Atkinson.
And BlueBay's Mr. Kemp said loans are “the most spoken about topic over the last few weeks. From a top-down perspective, if you are looking for low-volatility income and a natural hedge against interest rate volatility, that is the place to go. It is quite a compelling and topical story. If you are worried about the cycle running its course but still want income and downside protection ... that is an easy conversation,” he said.
But BNP Paribas is holding its exposure in cash, “mainly because we feel things have got so far ahead of themselves there will be a correction, and we need cash to deploy.” At the point of a correction, those able to supply liquidity to the market “will get extra premium ... in times of stress. It is not very exciting sitting on cash, but from our perspective and a research process perspective, that is looking like the best option at this point in time,” said Mr. Graham.
This article originally appeared in the February 6, 2017 print issue as, "Prospects on high yield muted after satisfying year".