Strategy view: the good, the bad and the ugly

Bouts of selling pressure across global leveraged finance markets in 2015 will reveal ‘hidden treasure’ for investors.

December 2014

Key points

  • Dispersion of returns in global leveraged finance market to continue in 2015, as central bank policy diverges.
  • US economic growth of 3% in 2015 bodes well for the US high-yield bond market.
  • European high-yield bonds outperform US high-yield again in 2014, up 6.2% this year.
  • Asian high-yield bonds expected to lead returns in 2015, aided by a favourable macroeconomic backdrop and attractive valuations.

The story so far

Looking back at the global leveraged finance markets in 2014, there have been good performers such as returns from Asian high-yield bonds of 7%. Relatively bad performers such as US bank loans at 2.9%. And downright ugly ones such as oil-service companies’ bonds at 9.75%. We expect the dispersion of returns within the global leveraged finance market to continue, as central banks across the world go in different directions due to diverging regional growth expectations. 

Chasing the dollar

We expect demand for the US dollar to stay strong as investors search for attractive yields. But a stronger US dollar, plummeting oil prices, or another economic imbalance can all have considerable consequences. So, while we believe global leveraged finance markets will return 4-6% in 2015, certain pockets are still likely to exhibit good, bad and ugly performers.

US high-yield

The global high-yield bond market looks poised to end 2014 at a more attractive valuation than it started. This sounds counter-intuitive bearing in mind the strong performance of fixed-income from falling yields and record highs in the US equity markets. Yet global high-yield bonds have actually underperformed five to ten-year Treasuries and US equities, returning  4.4% in 2014 (to 28th November).

Benign banking policy

The high-yield bond risk premium (or spread widening) increased during the year, resulting in higher yields and lower prices. US equity markets have been largely supported by central bank policy, despite the Fed exiting its “quantitative easing” programme. Mario Draghi, president of the European Central Bank (ECB), is promising a €1 trillion expansion of the bank balance sheet. The Bank of Japan is also expanding its QE programme. More recently, Chinese authorities lowered rates. So policy has been rather accommodative within those countries where economic growth is low or declining.

Opposite ends of the cycle

Entering 2015, the US is at the opposite end of the monetary cycle to the Eurozone and Japan. Indeed, the Federal Reserve is expected to raise interest rates in mid-2015. US economic output expanded at an annualised rate of 5% in the third quarter, and we believe the economy will grow around 3% in 2015. With the US Consumer Price Index (CPI) at 1.3% and Core CPI at 1.7% in November, the threat of inflation is limited and affords the Fed time to be patient. If labour markets continue to tighten, however, inflation could increase to the central bank’s 2% threshold, encouraging the Fed to adopt a more aggressive monetary policy. High-yield bonds have typically performed well in a US growth environment. So 2015 bodes well for company profitability, low default rates, and high-yield bond performance. 

European high-yield

European high-yield bonds again outperformed those in the US in 2014 on a currency-hedged basis. They have returned 6.2% this year, compared to 4.9% for Sterling high-yield bonds and 4% cent for US high-yield bonds. The latter experienced several bouts of volatility during 2014 as comments from Fed Chair Janet Yellen on high-yield valuations prompted redemptions from mutual funds. European high-yield bonds were supported by increasingly accommodative monetary policy and a declining government bond yield curve across all maturities.

Differing regional performance

We believe Asian high-yield bonds will lead returns in 2015, aided by a favourable macroeconomic environment and attractive valuations. At the same time, we do not expect a wide deviation in performance in the global leveraged finance markets. European high-yield, with significantly lower yields and spreads than other regions, is expected to perform close to US high-yield, but with less volatility due to contrasting outlooks for monetary policy. US bank loans could be poised to benefit from rising short rates in 2015, especially with a similar yield to high-yield bonds, after underperforming high-yield bonds in 2014.

Default rates

Default rates are expected to remain low for 2015 in both North America and Europe. Moody’s trailing 12-month global high-yield default rate was 2.3% at 31st October 2014 and is expected to increase to 2.4% in twelve months’ time. By contrast, the long-term average default rate is nearly 5%. Asian defaults have been low in 2014 at an estimated 1.6%, versus 1.9% in 2012. Moody’s forecasts a 2.9% default rate for Asia in 2015 due to several expected defaults in China, though rates should remain low compared to historical averages.

Monetary policy outlook

We expect the Fed to be the first major central bank to raise rates in mid-2015, although the Bank of England may not be far behind. While there is much debate about using the rate of unemployment as an indicator of labour market slack, a broader range of measures – including the Fed’s new labour market conditions index – points to considerable tightening. Economy-wide capacity utilisation estimates paint a similar picture.

Underpinning the recovery

The recovery is being underpinned by a reduction in the drag from fiscal measures, an increase in household wealth, a stronger housing market, continued employment gain, and fewer concerns over political shenanigans in Washington. We expect annual growth in GDP of 3% between 2014 and 2017. As above-trend growth comes up against narrower capacity utilisation gaps, however, inflation should increase. There might still be downward pressure on goods prices if Chinese growth is weaker than expected. In contrast, the trend in the prime age labour force – which helps determine the prices of durable goods – is unlikely to be the deflationary force it’s been over the last few years.

Low correlation

With a historically low correlation to interest rate volatility, high-yield bonds usually aid diversification in a rising rate environment. But tighter spreads make the correlation between bonds and rate volatility slightly positive, reducing the benefits. For example, the correlation of high-yield bonds to ten-year Treasuries is approximately 0.4. The correlation for investment-grade corporate bonds to the ten-year Treasuries is by contrast around 0.9. 

The good: Asian high-yield

Asia has been regarded as a safe haven among emerging markets, especially given the idiosyncratic nature of regions like Russia, Ukraine, Brazil, Argentina and Venezuela. Asian corporate high-yield performed well in 2014 with a 7% return, compared with 3.9% for emerging markets in general as measured by JP Morgan’s CEMBI High-Yield index. It has, however, underperformed Asian investment-grade corporates (7.5%), quasi-sovereigns (8.3%) and sovereigns (12.9%). This is largely due to the rally in longer-duration bonds. 

Cuts in Chinese lending rates

With clear evidence of a slowdown in global growth over the last few months, we expect Asian central bank policy to remain accommodative in 2015. Continued low interest rates should increase the attractiveness of higher yielding fixed-income asset classes. And high-yield investors will take comfort from the expectation of low default rates. The People’s Bank of China’s (PBOC) recent decision to cut lending rates is clearly positive for Chinese credit. And many expect further cuts as policymakers seek to ensure stable employment and economic momentum.

Tailwind for Asian corporate

This should provide a decent tailwind for Asian corporate high-yield, with China accounting for nearly half of the market and many sectors likely to experience a cyclical upswing in earnings (e.g. property developers and basic industries). Lower commodity prices are a positive, given all countries in the region except Malaysia are net oil importers.

Overall, we expect Asian corporate high-yield to return between 5% and 8% in 2015. Key risks to this view remain a policy mistake in China, renewed global recession, and adverse flows of funds as investors re-allocate back to the US.

Asia has been a safe haven among emerging markets, given the idiosyncratic issues in places like Russia, Ukraine, Brazil, Argentina and Venezuela.

Todd Youngberg, CFA

Global Head of Credit

The bad: Bank loans

Bank loan mutual funds posted 19 straight weekly net outflows in the period to 29 November 2014, after a 95-week inflow streak ended earlier in the year. While a 2.9% return is hardly attractive, they have performed remarkably well in the face of negative technical selling pressure. With short rates potentially increasing in 2015, default rates staying low, and a similar yield to that of high-yield bonds, bank loans will look especially attractive on a risk-adjusted basis – particularly so as they are secured and higher in the capital structure than high-yield.

The ugly: Energy

The energy sector comprises 11.6% of the global high-yield market and yields 7.2%, or 1.5% above the market. Energy has returned -5.68% this year, underperforming the global high-yield bond market by over 10%. Last month’s Opec decision to keep oil production stable caused oil prices to plummet to a four-year low. This is likely to test the higher-cost US shale oil producers. The impact of plunging oil prices has been felt mainly in the US high-yield bond market: the oil field services sub-sector returned -10.1% this year.

We believe the oil service sub-sector will be a potential area of defaults in 2015. But as the value of outstanding debt only accounts for 1.5% of the global index, it should not cause defaults to escalate significantly.

Summary

We expect bouts of technical selling pressure across the global leveraged finance markets to present buying opportunities, especially against the backdrop of strong fundamentals and low-to-stable default rates for the foreseeable future. 2015 may be feeling like a sequel to the famous Spaghetti Western, as investors hunt for hidden treasure in a market bound to produce pockets of good returns as well as bad and ugly ones.