Download What Might Investors Expect from US High Yield?

FIXED-INCOMEINSIGHTS
WhatMightInvestorsExpectfromU.S.HighYield?
March16,2017
ZaneE.Brown
Partner,FixedIncomeStrategist
852Views
Here,weweighanumberoffactorsthatmayaffecttheperformanceofthe
high-yieldmarketinthemonthstocome.
InBrief
Af terastrongshowingin2016,U.S.high-yieldsecuritieshadasolidstartto2017.Butwhat
maylieaheadf ortheassetclass?
Itdoesnotseemlikelythatreturnsf orthehighyieldwillcontinueatthesametrajectory.
Nonetheless,therearesomepositivef actorsf ortheassetclass.
First,aJ.P.Morganmeasureof def aultriskwasrecentlyatbelow-averagelevels.Also,tax
andf iscalpolicyinitiativesmayhelpspurf asterU.S.economicgrowth.
Finally,ananalysisof pastperiodsof risinginterestratesshowsthathighyieldandother
credit-sensitiveassetclassesoutperf ormedhigher-qualitysegmentsof thef ixed-income
market.
Thekeytakeaway—Withinthecontextofthefactorsmentionedabove,concernsabout
potentialovervaluationofthehigh-yieldmarketappeartobeoverstated.
Af terastellarshowingin2016,U.S.high-yieldsecuritieshavecontinuedtoperf ormwellthrough
earlyMarch2017.YieldspreadsrelativetoU.S.Treasurysecuritieshavemovedbelowlong-term
averages,raisingconcernsof potentialovervaluationinthehigh-yieldsectorand,f orsome
investors,f earof areversiontothemeanandtheassociatedpotentialpricedeclines.
Whatmaylieaheadf ortheassetclass?Prospectsf orf urtherratehikes(af tertheoneannounced
onMarch15)bytheU.S.FederalReserve(Fed),pro-growthf iscalinitiatives,andhigherinf lation
appearpoisedtoinf luencethehigh-yieldsectoroverthenext12–24months.Anexaminationof
currentf actorsaf f ectinghighyield,andananalysisof perf ormanceduringsimilarhistorical
periods,shouldhelpinvestorscraf tanappropriatestrategyf ortheperiodahead.
ManagingExpectations
TheJ.P.MorganHighYieldIndex,awidelyf ollowedsectorbenchmark,returned18.9%in2016,
helpedbyexposuretotheriskiestandbestperf orming‘CCC’ratedcredits,whichreturned
34.7%.1Forthef irsttwomonthsof 2017,theindexreturnedarelativelyattractive2.7%,with
‘CCC’issuesagainbestinghigher-qualitycreditswithareturnof 5.2%.
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Continuationof thisreturntrajectoryisunlikely,eventhoughreturnsshouldbef avorablerelativeto
otherf ixed-incomealternatives.Theindexbegan2016withayieldof 9.28%andaspreadover
U.S.Treasurysecuritiesof 757basispoints(bps).Sincethattime,theyieldontheindexhas
declined,to6.19%,andthespreadhasnarrowed,to442bps.Another3%declineinyields,
mirroringthereturnsof thelast14months,wouldbedif f icultwiththeindex’syieldsalreadyclose
to6.0%,U.S.inf lationcreepinghigher,andtheFedintentongraduallyraisingrates.However,in
suchanenvironment,ahighsingle-digitreturnmaybearelativelyattractivealternative.
Thecurrentyieldspreadof 425–450bpsisnarrowerthanthe20-yearhigh-yieldindexmedianof
573bps,butthislevelmaynotrepresentextraordinaryovervaluation,normayitimplyanimminent
reversiontothemean.Duringpastcreditcyclesin1987,1997–98,andin2005–07,spreadson
thehigh-yieldindexnarrowed,tobelow350bps.Thisisnoassurancethatspreadswillcontinueto
narrowf romcurrentlevels,butitdoesinviteinvestorstoquestionwhethervaluationsaretoohigh.
Investorsmaydemandawiderspread,orhigheryieldf romhigh-yieldinvestments,if thereisan
increasedriskof def ault,orpooreconomicconditionsleadingtolowerissuerprof itability,orif
betterinvestmentalternativesbecameavailable.
Today’sEnvironment
Yettoday,theseconsiderationsseemtosupportspreadsnarrowerthantheiraverage,notwider.
Forinstance,def aultriskrecentlywasatbelow-averagelevels.J.P.Morgancitesthelong-term
def aultrateof theU.S.high-yieldmarketascloseto3.8%,comparedwitha2.8%f orthe12
monthsendedFebruary2017,andtoJ.P.Morgan’sprojectionsof 2.5%f or2017.Further,
def aults(asof February2017)wereonly0.70%(excluding,however,theenergyand
metals/miningsectors).Theselower-than-averagedef aultratesmaysuggestthattoday’slowerthan-averagespreadsareappropriateandconsistentwithreduceddef aultrisk.
Economicgrowthisanotherf actorthattodaymaybef avorablef orthehigh-yieldassetclass.
Expectationsf orU.S.growthin2017and2018maybesupportedbyexpansionaryf iscalpolicies,
includinginf rastructurespendingandtaxref orm,whichmayimprovecorporateprof itabilityand
otherf inancialmetrics.This,inturn,mayreduceriskf ortheassetclass—andtheyieldinvestors
demandtoownhigh-yieldbonds.
Further,whencomparedtof ixed-incomeinvestmentselsewhere,U.S.high-yieldsecuritieslook
relativelyattractive.ComparedwithmanyEuropeanandJapanesealternatives,U.S.highyield
of f ersmoreattractiveincomeaswellaslessinterest-rateriskinwhatmaybeanupcomingperiod
of graduallyrisingglobalinterestrates.
RisingRates
Af terconsiderationof def aultrisk,thepotentialimpactof pro-growthf iscalproposalsandthe
paucityof otherattractivef ixed-incomealternatives,itisnotsurprisingthatU.S.high-yield
securitiesaretradingwheretheyaretoday.Furtheranalysisof theperf ormanceof highyieldin
pastrising-rateenvironmentsprovidesyetanotherconsideration,especiallyinanenvironment
whereinf lationandmonetarypolicymaywreakhavoconinterest-sensitivef ixed-income
categories.
Table1identif ieseightperiodsof risingratesoverthelast25yearsandcomparesthe
perf ormanceof interest-sensitiveassetclassessuchasthe10-yearU.S.Treasurynoteandthe
broadf ixed-incomebenchmarkBloombergBarclaysU.S.AggregateBondIndex(Bloomberg
BarclaysAggregate)withhigh-yieldsecuritiesandotherlessrate-sensitiveassetclasses.
Table1.Credit-SensitiveBondSectorsSuchHavePerformedWellinPastPeriodsof
RisingRates
Returns(month-end)duringperiodsofgreaterthana100basis-pointriseinthe10-yearU.S.
Treasuryyield
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Source:Morningstar.
1Citigroup10-YearTreasuryBondIndex.
2 BloombergBarclaysU.S.AggregateBondIndex.
3Bof AMerrillLynchU.S.CorporateBBB-Rated1-3YearIndex.
4 Bof AMerrillLynchHighYieldMasterIIIndex.
5 CreditSuisseLeveragedLoanIndex.
6 Bof AMerrillLynchAllConvertiblesAllQualitiesIndex.
7 S&P500Index.
Pastperformanceisnoguaranteeoffutureresults.Perf ormanceduringothertimeperiodsmayhavebeen
dif f erentornegative.Otherindexesmaynothaveperf ormedinthesamemannerundersimilarconditions.For
illustrativepurposesonlyanddoesnotrepresentanyspecif icportf oliomanagedbyLordAbbettoranyparticular
investment.Indexesareunmanaged,donotref lectthedeductionof f eesorexpenses,andarenotavailablef ordirect
investment.
PortfolioConsiderations
Table1illustratesseveralhistoricalrelationshipsthatcouldhelpinvestorsdevelopastrategyf ora
rising-rateenvironment.First,includinghigh-yieldbondsmaybeanappropriateportf olioresponse.
High-yieldbondshaveprovidedconsistentlypositivereturnsduringtheperiodsof risinginterest
rates(depictedinthetable),comparedtogenerallynegativeperf ormancef orlonger-term,highqualityf ixedincomesuchasthe10-yearU.S.TreasuryandtheBloombergBarclaysAggregate
BondIndex.Asecondcategorytoconsidermaybef loating-rateloans(essentiallybankloansto
high-yieldcompanies)thatalsohaveprovidedpositivereturnsduringrising-rateenvironments,but
withaslightlydif f erentriskprof ilethantraditionalhigh-yieldbonds.
Anotherconsiderationmaybeamulti-assetportf oliothatincludeshighyieldandseveralof the
otherassetclassesthatoutperf ormedduringtheperiodscoveredinTable1.Suchacombination
mightof f eramorediversif iedapproachf orsomeinvestors.And,f inally,if aninvestor’sriskprof ile
tiltsawayf romtraditionalhighyield,short-termcorporatebondsmayof f eranef f ective
alternative.
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Theinclusionof highyieldmaybeanappropriateportf olioresponsetotheupcomingenvironment,
butsuchamoveshouldconsiderinvestorpref erencesaswellasotherexpressionsof riskinthe
portf olio.Regardlessof whichstrategyismostappropriatef orindividualinvestors,current
valuationof high-yieldsecuritiesmaynotbeexcessivewhenoneconsidersexpecteddef ault
rates,projectedeconomicconditions,thelackof attractivef ixed-incomealternatives,andthe
historicalperf ormanceof theassetclassduringperiodsof risingrates.
1Allindexreturnandspreaddataaref romJ.P.Morgan.
ANoteaboutRisk:Thevalueof investmentsinf ixed-incomesecuritieswillchangeasinterestratesf luctuateandin
responsetomarketmovements.Generally,wheninterestratesrise,thepricesof debtsecuritiesf all,andwhen
interestratesf all,pricesgenerallyrise.Bondsmayalsobesubjecttoothertypesof risk,suchascall,credit,liquidity,
interest-rate,andgeneralmarketrisks.High-yieldsecurities,sometimescalledjunkbonds,carryincreasedrisksof
pricevolatility,illiquidity,andthepossibilityof def aultinthetimelypaymentof interestandprincipal.Moreover,the
specif iccollateralusedtosecurealoanmaydeclineinvalueorbecomeilliquid,whichwouldadverselyaf f ectthe
loan’svalue.Longer-termdebtsecuritiesareusuallymoresensitivetointerest-ratechanges;thelongerthematurity
of asecurity,thegreatertheef f ectachangeininterestratesislikelytohaveonitsprice.Lower-ratedbondsmaybe
subjecttogreaterriskthanhigher-ratedbonds.Noinvestingstrategycanovercomeallmarketvolatilityorguarantee
f utureresults.Statementsconcerningf inancialmarkettrendsarebasedoncurrentmarketconditions,whichwill
f luctuate.
Forecastsandprojectionsarebasedoncurrentmarketconditionsandaresubjecttochangewithoutnotice.
Projectionsshouldnotbeconsideredaguarantee.
Thisarticlemaycontainassumptionsthatare“f orward-lookingstatements,”whicharebasedoncertainassumptions
of f utureevents.Actualeventsaredif f iculttopredictandmaydif f erf romthoseassumed.Therecanbenoassurance
thatf orward-lookingstatementswillmaterializeorthatactualreturnsorresultswillnotbemateriallydif f erentf rom
thosedescribedhere.
Statementsconcerningf inancialmarkettrendsarebasedoncurrentmarketconditions,whichwillf luctuate.Thereis
noguaranteethatmarketswillperf orminasimilarmannerundersimilarconditionsinthef uture.
TreasuriesaredebtsecuritiesissuedbytheU.S.governmentandsecuredbyitsf ullf aithandcredit.Incomef rom
Treasurysecuritiesisexemptf romstateandlocaltaxes.AlthoughU.S.governmentsecuritiesareguaranteedasto
paymentsof interestandprincipal,theirmarketpricesarenotguaranteedandwillf luctuateinresponsetomarket
movements.
Abasispointisoneone-hundredthof apercentagepoint.
Durationisthechangeinthevalueof af ixed-incomesecuritythatwillresultf roma1%changeinmarketinterest
rates.Generally,thelargeraportf olio’sduration,thegreatertheinterest-rateriskorrewardf orunderlyingbond
prices.
Abondyieldistheamountof returnaninvestorwillrealizeonabond.Thoughseveraltypesof bondyieldscanbe
calculated,nominalyieldisthemostcommon.Thisiscalculatedbydividingtheamountof interestpaidbythef ace
value.
TheBofAMerrillLynchU.S.HighYieldMasterIIConstrainedIndextrackstheperf ormanceof USdollar
denominatedbelowinvestmentgradecorporatedebtpubliclyissuedintheUSdomesticmarket.Qualif yingsecurities
musthaveabelowinvestmentgraderating(basedonanaverageof Moody’s,S&PandFitch),atleast18monthsto
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f inalmaturityatthetimeof issuance,atleastoneyearremainingtermtof inalmaturityasof therebalancingdate,a
f ixedcouponscheduleandaminimumamountoutstandingof $100million.
TheBofAMerrillLynchU.S.CorporateBBB-Rated1-3YearIndexisanunmanagedindexcomprisedof U.S.dollar
denominatedinvestmentgradecorporatedebtsecuritiespubliclyissuedintheU.S.domesticmarketwithbetweenone
andthreeyearremainingtof inalmaturity.
TheBofAMerrillLynchAllConvertibles,AllQualitiesIndexcontainsissuesthathaveagreaterthan$50million
aggregatemarketvalue.TheissuesareU.S.dollar-denominated,soldintotheU.S.marketandpubliclytradedinthe
UnitedStates.
TheBloombergBarclaysU.S.AggregateBondIndexrepresentssecuritiesthatareSEC-registered,taxable,and
dollardenominated.TheIndexcoverstheU.S.investment-gradef ixed-ratebondmarket,withindexcomponentsf or
governmentandcorporatesecurities,mortgagepass-throughsecurities,andasset-backedsecurities.Totalreturn
comprisespriceappreciation/depreciationandincomeasapercentageof theoriginalinvestment.
TheCitigroup10YearTreasuryBondIndexisabroadmeasureof theperf ormanceof themedium-termU.S.
Treasurysecurities.
TheCreditSuisseLeveragedLoanIndexisdesignedtomirrortheinvestableuniverseof theU.S.dollardenominatedleveragedloanmarket.
TheS&P500 ® Indexiswidelyregardedasthestandardf ormeasuringlargecapU.S.stockmarketperf ormanceand
includesarepresentativesampleof leadingcompaniesinleadingindustries.
Indexesareunmanaged,donotref lectthedeductionof f eesorexpenses,andarenotavailablef ordirectinvestment.
Thecreditqualityof thesecuritiesinaportf olioisassignedbyanationallyrecognizedstatisticalratingorganization
(NRSRO)suchasStandard&Poor’s,Moody’s,orFitch,asanindicationof anissuer’screditworthiness.Ratingsrange
f rom‘AAA’(highest)to‘D’(lowest).Bondsrated‘BBB’oraboveareconsideredinvestmentgrade.Creditratings‘BB’
andbelowarelower-ratedsecurities.Highyielding,non-investment-gradebondsinvolvehigherrisksthaninvestmentgradebonds.Adverseconditionsmayaf f ecttheissuer’sabilitytopayinterestandprincipalonthesesecurities.
Theopinionsintheprecedingcommentaryareasofthedateofpublicationandaresubjecttochange.Additionally,the
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