US high-yield outlook: The opportunity in risk
Carl ‘Pepper’ Whitbeck, Global Head of High Yield and US Active Fixed Income, examines what he expects 2019 to deliver
Given the manner in which 2018 panned out, especially in the final weeks, it is understandable if investors approached 2019 with some trepidation. During the final three months of the year, the US high yield market gave away all its gains for 2018, posting a -4.67% return for the fourth quarter, marking its worst quarterly return since 2015.*
Moving into 2019, there appeared to have been plenty of fear priced into the market. However, we believe the significant repricing that took place in the final weeks of the year has provided fresh opportunities and we expect it has increased the range of possible return outcomes for 2019.
Broadly speaking we believe the current environment has provided the market with the potential for a higher return. Rigorous security selection remains key and while risks remain prominent, we think there are several reasons to be cautiously optimistic about US high yield as we move into 2019.
The economic cycle
We believe that we will see a slowdown in US economic growth in 2019, at least relative to 2018. However, we do not see GDP turning negative. In recent years, slow economic growth has proved to be a tailwind for US high yield, as it has allowed companies to continue to meet debt obligations while at the same time kept the Federal Reserve from turning too hawkish. However, investor sentiment suggests that recent slow growth is being viewed as an indicator that we are reaching the end of the cycle and therefore the end of the Goldilocks scenario high yield has experienced in recent years. We believe this pessimism should be acknowledged and risk aversion could remain high, given the cycle fears. While we would expect poorly performing credits to be increasingly penalised by investors, we think the majority of high yield investments could still perform well during a slow growth environment in 2019.
Default Risk and fundamentals
In our view, credit fundamentals within the high yield market remain positive. What seems unique about this current cycle is that the US high yield market has not seen the aggressive risk taking which has tended to occur toward the end of previous cycles – that is, if we are actually close to the end of the cycle. This does not mean that aggressive risk taking has not occurred, as we have witnessed this behavior happening in some markets such as US investment grade and leveraged loans. We are taking seriously some of the earnings misses that occurred in 2018 and are closely watching results to see if there is a greater macro concern regarding rising costs and margin compression. For now, we are expecting potentially positive year-on-year earnings growth for most of our portfolio holdings in 2019. We also expect a below average default rate of between 1.5% and 2% this year. While we see few reasons why default rates should rise markedly in 2020, there are risks of a higher default rate further out.
Our base case is that new issue supply remains low, and this, combined with coupon generation, could provide support. Such a boost could potentially minimise losses relative to equity markets in a risk-off environment. We could see a scenario where management teams are more proactive with refinancing short to medium term securities, taking an economic hit with increased interest costs in order to extend their maturity runway further. While this would likely lead to more supply, it could also possibly lead to a better return for short duration strategies.
A more dovish Fed
Recently we have seen a significant change in the market’s expectations of future Fed policy. Prior to December many market participants were expecting three to four interest rate hikes this year. Today, it appears that some investors are expecting a pause, with some quarters even predicting a cut. Certainly, the risk of a policy error and a subsequent recession is on the minds of many investors.
At its January meeting, the Bank’s rhetoric certainty indicated that it was not intending to hike interest rates anytime soon.
our part, we expected as much. We believe the Fed will placate the market and hold off on tightening until stability returns. Whether or not policymakers resume rate hikes will depend on economic data and political developments such as the trade situation with China. now, we anticipate the Fed will possibly raise rates just once in 2019.
we believe there is a wider range of potential outcomes for 2019 than has been the case in recent years. The market has begun to recover in the first few weeks of January and we expect this to continue, certainly in the first half of the year. We expect progress on the trade front with China and a more dovish Fed. Both these factors should help stabilise markets, and we expect a strong high-yield market in the early part of 2019. While we expect volatility to remain present throughout 2019, we are still forecasting a coupon-like return of between 6% and 8%.
* ICE BofA Merrill Lynch US High Yield Index as at 31 December 2018
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