US high-yield outlook: Fundamental and technical factors aligned
Carl ‘Pepper’ Whitbeck, Global Head of High Yield and US Active Fixed Income, examines the prospects for the US high-yield market.
We live in a turbulent world. So far this year, we have seen international trade conflicts intensify, the US Treasury yield curve invert and central banks return to easing monetary policy.
The backdrop could certainly be better. Yet, despite all this, the US high-yield market has returned over 11% in the first nine months of 2019, and looking ahead, we continue to be optimistic.
Of course, the trade conflict between the US and China is disruptive for markets and the world’s economies.
In addition, the fact that 10-year Treasury yields are lower than those on three-month bills means that markets are less certain about the near-term outlook of the US economy.
Still, with unemployment well below 4% and the US economy growing at 2% in the second quarter, following a 3.1% rise in the first three months, we believe this risk is overstated – especially as consumer spending makes up approximately two-thirds of US economic growth.
Despite that, monetary policy has shifted from expected tightening towards the end of last year to an increasingly dovish stance from global central banks. The expectations for lower rates have significantly added to positive market momentum during 2019 and in September, the Federal Reserve again lowered the target range for its key interest rate, as expected, by 25 basis points to between 1.75% and 2%.
The market is pricing in another cut in late October with an 80% probability.
The right time for high yield
Bearing all this in mind, and even though recession risks appear to be higher than before the yield curve inversion, we believe the market environment for high-yield bond investments remains benign – both from a fundamental and technical perspective.
High-yield issuers remain resilient with a healthy level of interest coverage, which reached 4.5 times in 2018 while the Fed was raising interest rates and remained around the same level in the first quarter of 2019.
Debt leverage only ticked up slightly in the first quarter of 2019 to 4.1 times from 4.0 throughout most of 2018. However, these levels remain significantly below the peaks of 5.2 times in 2009 and the recent peak of 4.6 times in 2016.
Overall, default rates are estimated at 2.8% in 2019, while expectations for 2020 remain low at 2%  This compares to a long-term average default rate of 3.4% for high-yield bonds.
The recent increase in expected defaults mainly reflects some weakness amongst energy-related issuers and we might see the default risk in that sector of the high-yield market increase. This is because oversupply has been pushing prices for natural gas to unsustainably low levels. But this is an isolated risk to this sector and is idiosyncratic to specific credits, not the entire market.
A rapidly growing leveraged loan market and refinancing in the high-yield bond market have seen the volume of outstanding high-yield bonds shrink. Meanwhile, we are seeing investors reinvesting their coupon payments back into high yield, causing increasing demand.
This supports, what we view as a positive technical backdrop for the asset class.
Even if international trade conflicts and worries over a recession intensify, in our view, given the supportive fundamental and technical characteristics of the US high-yield market, we believe it remains an attractive long-term investment.
 Source: AXA IM, Perspectives US High Yield, Month Ending August 2019. Year-to-date return for ICE BofA Merrill Lynch US High Yield Index 11.15% as of 31 August 2019. Past performance is not a reliable indicator of future results.
 JP Morgan, US High Yield Credit Fundamentals 1Q 2019.
 See footnote 2.
 See figure. JP Morgan, Default Monitor, 2 October 2019.
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