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Issuance of US high-yield debt is growing despite the prospect of further interest rate hikes in 2017. But an improving economic outlook should offset fears around refinancing risk, says Kevin Mathews.
Financial markets in the US have rallied strongly since the beginning of 2017, thanks in part to the ‘Trump effect’. Investors are confident President Trump’s policies – particularly the pro-growth trifecta of tax cuts, deregulation and infrastructure spending – will boost corporate profits. Trump’s influence is most conspicuous in the equity markets: the S&P 500 Index has risen to levels last seen during the dot-com boom of the 1990s. But US high-yield credit has also seen an impressive rally.
On February 23, the average yield on triple-C rated bonds fell to below 10 per cent, compared with 20.92 per cent a year earlier, according to Bank of America Merrill Lynch data, and tightened further to 9.69 per cent on March 1. The average yield on double-B rated bonds has also fallen, albeit less dramatically, to 4.42 per cent as of March 1, down from 5.94 per cent a year earlier. As well as an improving economic outlook, the tightening in high-yield credits has been driven by a recovery in oil prices since early 2016, which has quelled fears over potential defaults in the energy sector.
Companies are taking advantage of resurgent demand by issuing new bonds and refinancing existing debt. Over $32.6 billion of high-yield debt was priced in January 2017, compared with $9.2 billion over the same period a year earlier. JP Morgan forecasts total high-yield issuance of $300 billion in 2017, up from $286.2 billion in 2016, with the majority of this amount – some $165 billion – comprising refinancing of existing bonds.
With the Federal Reserve expected to raise interest rates at least twice this year, companies are looking to refinance their debts before borrowing costs begin to rise. But much refinancing remains to be done. According to Moody’s, just over $1 trillion of US high-yield debt will mature over the next five years,1 prompting fears in some quarters of a ‘refinancing wall’ that the market will struggle to absorb, especially if Trump fails to follow through on his policies or energy prices slide.2
In this Q&A, Kevin Mathews, Head of Global High Yield at Aviva Investors, explores the factors behind the US high-yield rally, whether concerns around refinancing risk are justified and potential investment opportunities in the asset class.
How do you expect issuance in US high yield to develop this year relative to 2016?
The whole market is up on an absolute basis compared with last year. The election of Donald Trump, and the expectations he will deliver stronger economic growth, may have played a role in this. We will have to wait for the substance of Trump’s policies on tax and infrastructure spending, but the market is optimistic.
Issuance is strong across all sectors. As the Federal Reserve is becoming active again, many corporate treasurers have decided now is the time to come to the market and refinance. The majority of the activity in the high-yield market in early 2017 – some 60 per cent – has involved refinancing of existing issues.3 We have also seen a substantial amount of refinancing in the leveraged loan market.
How has Trump’s election affected the high-yield market?
Investors are optimistic the US will avoid recession in the next year or two, whereas the view before the election was that there would be a slowdown in 2017. This optimism is driving a ‘risk-on’ rally; triple-C rated bonds are outperforming, for example. However, it’s important to remember that this time last year we were at the bottom of the market. Oil prices had fallen to below $28 a barrel in February 2016 and the energy sector was underperforming. What we’re seeing now is a normalisation of the market compared with its low point last year, rather than a dramatic rise in historical terms.
With interest rates set to rise and noise around the ‘refinancing wall’, could the market come under pressure?
The idea of a troublesome wall of maturing debt has been a trendy topic of conversation for the last four or five years, but it has never actually materialised. If investors don’t like the prospect of a wave of maturing debt they can protect themselves by lending longer and spreading out the maturities of the bonds they own. Will some companies come under pressure if they have to refinance at higher rates? Possibly. But fears of a maturity wall have been overblown. Companies always have other ways they can access the capital markets if they can’t issue debt; they can go to the leveraged loan market, for example, or they can issue equity.
Does the increasing appetite for high-yield debt reflect strengthening market fundamentals?
The general quality of issuance declined in the latter half of 2016, with many issuers highly leveraged. But the quality has now levelled out and it remains fairly stable. Defaults on high-yield bonds and loans in January totalled $7.3 billion, the highest recorded for nine months.3 But most of that amount was due to the default of a single large issuer, technology company Avaya.
Both Moody’s and Fitch expect default rates to fall in 2017, thanks to strong economic growth and rising commodities prices, which has improved the liquidity position of issuers in the energy sector. According to Fitch, the trailing 12-month default rate in the energy sector stood at 19 per cent as of January 30 but will fall to three per cent by the end of the year.4
Which sectors look attractive in the current environment?
We are focusing on issuers in the healthcare sector, which we believe will outperform despite Trump’s promise to repeal the Affordable Care Act and enact a wider overhaul of the healthcare industry.
The energy sector accounts for around four-fifths of US high-yield debt and has been the big swing sector over the last 12 months as oil prices have rallied. We believe the market is too optimistic about the prospects for oil prices over the medium term, although we are selectively adding exposure to energy companies that have more conservative capital structures.
Overall, we are focusing on higher-quality issuers and avoiding triple-C rated names, despite the recent outperformance of these bonds, because they will be more sensitive to a reversal in energy prices.
Does US high yield still offer good value relative to other markets?
Yes. In Europe, the picture is more uncertain now than it has been in previous credit cycles. The European Central Bank (ECB) is still easing, but it will taper its asset purchases through the rest of the year, which could lead to higher volatility, as could heightened political risk. The upcoming French election and negotiations over the UK’s exit from the European Union are causing uncertainty in some quarters.
Because interest rates are currently lower than in the US, European bondholders are likely to suffer more of an impact as rates rise; the US market offers a yield advantage and therefore more of a cushion for investors in a rising-rate environment.
3. JP Morgan
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at March 6, 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.