Further Potential Upside in High Yield Bonds Despite Recent Rally
TOM BUTCHER: Fran, here's been a rally in high-yield bonds in 2016. What's going on?
FRAN RODILOSSO: Tom, to say the least there's been a rally, although it's been more of a V-shaped trade in U.S. high-yield, and global high-yield in 2016. Up until February 11, the U.S. high-yield market, if you look at the BofA Merrill Lynch US High Yield Index (H0A0), it was down over 5%. That means that in the first 5 to 6 weeks of 2016, the Index had a return that was worse than its overall return for all of 2015 [-4.64%].
Since February 11, the market has rallied significantly, and is up more than 6% year to date [as of 04/30/16]. Some of the higher quality high-yield, the double Bs, as reflected by Merrill Lynch's fallen angel index [the BofA Merrill Lynch US Fallen Angel High Yield Index (H0FA)] are up 10% year to date through the early third week of April.
But in all cases, we have seen a continuation of what we saw largely in late 2015: a fairly significant selloff heading into early February. What sparked the selloff is an interesting question. Clearly the market came into 2016 concerned about several factors, one being the Federal Reserve (Fed), including the pace of Fed rate hikes, what this would do for yields overall, and what this would do for investors’ risk appetites. Since early February the market has changed its mind as the Fed has indicated that it will hold back on the pace of rate hikes. This has been one of the key driving factors.
TOM BUTCHER: Have all high-yield bonds moved in sync?
RODILOSSO: No, they have not. Although if you look at the Merrill Lynch Index [the BofA Merrill Lynch US High Yield Index (H0A0)], and break it down into 18 broad sectors within the high-yield universe, 17 of the 18 have shown positive returns year to date. Only the banking sector is slightly negative in its return. From that perspective, the high yield universe appears fairly correlated. But the bulk of return has been driven by two sectors, and those were the two sectors that drove negative returns last year: Energy and Basic Industry, the latter of which encompasses the metals and mining universe within high yield. These two sectors exerted downward pressure into early February, and have also driven the rally since February. One interesting note: of the 18 sectors I mentioned, 10 of them through mid-April still had wider, higher spreads versus U.S. Treasuries year to date. Now, they have had positive returns as Treasury yields have come down between 45 and 50 basis points, both the 5-year yields and the 10-year yields. Although the return on all those high yield sectors, except for banking, have been positive, their spreads right now are indicating a little more risk premium than they did on December 31, 2015.
It's important to note that really over a two-year period the high-yield market is still actually posting a negative return. And even over the last 12 months, a 2% negative return-- more than 2% negative return. And again, that downward movement in high-yield was largely driven by energy and these basic industry sectors. But also, it was driven more by the lower end of the credit spectrum-- so triple C single B issuers. If you look at their correlation, for instance, with oil prices, it's been extremely high-- not as high as with the double B or or high single B issuers. And so what you've seen is the higher quality end of the market has done better net over that two-year period, over the last 12 month period. And even year to date, when the market starts racing ahead, sometimes the lowest rated credits will lead that move. But that's why Fallen Angels have had actually a very important and positive impact on overall high-yield performance this year. And Fallen Angels as a category, which tend to be much higher percentage double B, Fallen Angels are 80% double B-- They've outperformed the high-yield market by more than several hundred basis points year-to-date.
BUTCHER: Fran, what are the current perceived risks and how has the market reacted to them?
RODILOSSO: I mentioned the interest-rate risk, the Fed risk, that prevailed at the beginning of the year, and that is still impacting the market. What if the Fed is behind the curve? Or what if the Fed just goes with the 4 to 5 planned moves over the next 12 months? In addition, the market came into 2016 very concerned about commodity prices, and this has not yet gone away. Clearly this has been a big driver other than the interest rate non-movement, or actually falling interest rates, and global central bank actions. It wasn't just the Fed saying it is going to move slower, it was Europe finding more ways to ease. It's the Bank of Japan wondering what it is going to do next.
There's downward pressure on interest rates across the globe, which also means more liquidity. This has helped boost commodity prices, which have been a big question for the high-yield market. More and more energy issuers have fallen into the high-yield sector as metals and mining issuers have been downgraded, and people began worrying about default rates. Expected default rates outside those two sectors are actually well below historical averages for the high-yield market, but well above historical averages within those two sectors: Energy and Basic Industry.
Overall markets are concerned about commodities, concerned about interest rates, and China is tied into both, mainly the commodity story. The China growth story dominated headlines for the first month or two of 2016, with the question being would China be able to engineer a soft landing? A question we had been asking for two years. But also would China need to devalue its currency more rapidly, or deploy some kind of macro devaluation? Thus far China seems to be navigating well, but not without increased leverage within its economy and obvious pockets of risk. Overall, however, the China story has become much less dominant in terms of the thinking of global investors.
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BofA Merrill Lynch U.S. High Yield II Index (H0A0) is comprised of below-investment grade corporate bonds (based on an average of Moody’s, S&P and Fitch) denominated in U.S. dollars. The country of risk of qualifying issuers must be an FX-G10 member, a Western European nation, or a territory of the US or a Western European nation.
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