Commentary from Pacific Asset Management, the manager of Pacific FundsSM Fixed-Income Funds.
High-yield bonds have staged an impressive rally since credit spreads (the difference in yield between a corporate bond and a Treasury security) reached a five-year high on February 11, 2016. The asset class has returned 10% over the past two months, driven by a variety of factors. In particular, the improvement in commodity prices, global central bank guidance, and positive technicals. In this article, we discuss the recent rally and catalysts that may determine the future direction of high yield.
The pendulum swings
Growth concerns, commodity declines, and deteriorating corporate outlooks helped push credit spreads to a high of 839 basis points (bps) on February 11, 2016. Historically, when high yield credit spreads cross 600bps, this has been associated with U.S. recessions. With credit spreads crossing 800bps (Chart 1), the pendulum of risk aversion had swung beyond just a U.S. recession. Intensifying the economic weakness were net outflows from high-yield bonds in the fourth quarter of 2015 and into 2016 was broad based, with many domestic sectors feeling the impact of the tightening financial conditions. Additionally, the weakness in
many U.S.-focused industries showed the recent sell-off to be more than just a commodity or China story.
Chart 1: High yield bond net outflows from spreads reached the highest levels since 2011 on February 11, 2016
Source: Barclays, as of April 22, 2016.
Chart 2: Extraordinary volatility in retail fund flows
Source: JP Morgan as of April 1, 2016
Entering February 2016 uncertainty surrounding central bank guidance, oil prices, and China’s economy drove negative sentiment and technicals to a point where high yield appeared to be oversold. It was in mid-February that several factors helped turn the negative tide. Central bankers took on a more dovish tone, as comments from Yellen, Dudley, and Harker helped calm fears of tightening financial conditions and concerns around negative interest rates.1 European Central Bank President Mario Draghi also indicated that he is ready to do further stimulus, notably allowing for the purchase of corporate bonds. Speculation that major oil producers would discuss either a production freeze or output cut helped oil move off of its lows. Technical conditions went from negative to positive as retail mutual funds saw significant inflows (Chart 2). The snapback has been significant, with the hardest hit sectors seeing the strongest total returns (Table 1). In determining what is next for high yield performance, we look to three catalysts; oil prices, U.S. economic growth, and China’s economy.
Table 1: A substantial rally across the hardest hit sectors (%)
|Index||Return since 2/11/16||1-Year Return|
|High Yield (HY)||12.38||–1.88|
|HY - Metals/Mining Sector||28.01||–7.43|
|HY - Energy Sector||39.35||–18.66|
|Source: Barclays as of April 22, 2016|
"So goes oil, so goes high yield." This has been a well-worn mantra for the past year as high yield has moved in
concert with oil (Chart 3). The volatility of oil and potential for another decline in crude prices remains a risk to credit markets; however, a stabilization of oil would allow for a better fundamental assessment of defaults, recoveries, and valuations. The Barclays High Yield Index Energy Sector has an average price of $81.75 and a yield of 10.49% as of April 30, 2016. A sustained move higher in oil prices would be a significant credit positive given the distressed prices of the energy sector.
Chart 3: High yield has been highly correlated with oil prices
Source: Barclays, St. Louis Federal Reserve, as of April 22, 2016
The U.S. economy has been resilient, but faces headwinds, and the path of least resistance is for lower Gross Domestic Product (GDP). Weakness abroad, deflationary pressures of a stronger U.S. dollar, and deteriorating corporate outlooks all add to heightened risk. While recent comments by the Federal Reserve have been more cautious, the general view continues to signal a tightening of monetary policy and subsequent financial conditions. At this time, the Federal Open Market Committee (FOMC) has a forecast of two rate hikes in 2016. The Institute for Supply Management (ISM) Manufacturing Index, which recently moved back above 50, had been in contraction for the prior six months, a rare event outside U.S. recessions (Chart 4). Concerns are that manufacturing weakness will spill over to the services sector, which accounts for 80% of private sector employment.
Chart 4: Leading indicators are pointing toward a slowdown in U.S. economic activity
Source: Institute for Supply Management, as of April 2, 2016
Conversely, other factors indicate positive signs for the U.S. economy. Employment conditions remain a bright spot with a strong trend in non-farm payrolls and even evidence of wage inflation. U.S. GDP forecasts are in the underwhelming, but positive range of 1.5%–2.5%. Corporate profits may be reverting to the mean of a slow-growth environment versus a structural drop in earnings. As credit spreads are still wider than historic norms, an improvement in economic data and corporate outlooks could provide the catalysts needed to sustain high yield’s recent performance.
In a recent Merrill Lynch Credit Investor Survey, a Chinese economic hard landing was cited as the greatest macro risk for 2016. The concerns regarding China are caused by its contribution to global GDP growth, impacts to commodity prices, and the lack of data transparency. Concerns also stem from the continued devaluation of the Renminbi and its impacts on global trade and finance. With China contributing more
than 15% to global GDP growth, a continued deceleration impacts corporate profits and credit risk. Stabilization in Chinese growth would be a positive driver toward global growth, and thus the performance of high yield.
Chart 5: Credit spreads remain wide despite the recent outperformance
Source: Barclays, as of April 22, 2016
Risk premiums to remain in 2016
High yield has staged an impressive rally over the past two months. Despite the recent performance, valuations continue to be historically attractive (Chart 5). With high yield credit spreads around 600bps, one could argue they are still pricing in a mild U.S. recession. These spread and yield levels have historically provided a "margin of safety" toward further downside risk, though we would be cautious on chasing the recent performance. While the degree of uncertainty has been reduced relative to the early part of this year, we believe the elevated premium expected for taking additional risk in high yield will likely continue as part of the 2016 investment landscape.
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1 Janet L. Yellen is Chair of the Board of Governors of the Federal Reserve System. William C. Dudley and Patrick T. Harker are Federal Reserve Bank Presidents of New York and Philadelphia, respectively.
Barclays High Yield Index refers to the Barclays U.S. High-Yield Index, which covers the universe of fixed rate, non-investment-grade debt. This index includes various sectors such as Metals/Mining and Energy.
Basis Points (bps): One basis point equals 0.01%.
Corporate is based on the Barclays U.S. Corporate Index, which includes publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be registered with the Securities and Exchange Commission (SEC).
High-Yield is based on the Barclays U.S. High-Yield Index, which covers the universe of fixed-rate, non-investment-grade debt.
The ISM Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute for Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries.
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