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.
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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.
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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.
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