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Global high yield has been among the stronger asset classes in 2017, but with spreads already squeezed, where can investors find value?
High yield bonds continue to enjoy strong demand as income-starved investors scour the market for a competitive yield. While this has driven some of the most attractive returns in the fixed income market this year, questions are being asked about the sustainability of this rally, especially as central banks wind down monetary support.
Kevin Mathews, Global Head of High Yield at Aviva Investors, assesses the outlook for the market and outlines his strategy response to shifting monetary policy.
With yields and spreads close to their lowest levels since the 2008 Global Financial Crisis, should investors be worried about valuations?
Global high yield bonds have had a good year so far, with a US dollar total return of 6.2%1 being much better than many investors had anticipated. Our expectation is that we are unlikely to see this kind of spread tightening and total returns for the remainder of the year.
While it’s difficult to make forecasts given where yields currently are, we think we could see a total return of between 1-3% over the next twelve months. In the next few months we might get a correction, but that would present a buying opportunity because we like what we see from a macro-economic and earnings standpoint.
Just as importantly, we do not feel the US Federal Reserve and the European Central Bank (ECB) are going to raise rates aggressively. While the longer-term trend will likely see rates move higher, we believe investors will have to wait some time for rates to move to a level that would do substantial damage to bond prices. This is not something that we are positioning for right now. For us, the main consequence of the richness of valuation is the need to be even more discriminating.
How significant is the threat of central bank policy tapering?
There has been little sign of a so-called “taper-tantrum” as yet. The market has barely flinched to comments made by the ECB and the Fed about tapering. Our own rate specialists believe the Fed won’t start to reduce the size of its balance sheet until sometime next year, and when it does it will likely be done in a gradual fashion. It should also be borne in mind that the Fed owns government and agency bonds rather than credit. This means balance sheet reduction probably won’t have a direct impact other than from a rate perspective. If anything, rates are now trending lower again after the sharp yield back-up seen at the end of June.
Europe is slightly different because the ECB is buying credit products as part of its quantitative easing program and rates are also a lot lower. So, as and when the ECB starts to sell off assets, we would expect to see a bigger impact on the credit market, though admittedly not as much in high yield as all ECB purchases have been in the investment-grade market. The ECB is also further away from tapering because it has yet to start raising rates.
We don’t think we will see tapering in Europe until the ECB starts to raise rates, which we believe is a number of months off yet. Our guess is that tapering won’t happen until late 2018 or early 2019. When it does, we expect the impact to be muted.
Do you see better opportunities in the US or Europe?
We have been fairly neutral, with a slight preference for the US. We are slightly overweight sterling versus euro, but that is more to do with credit selection. We tend to look at things both on an absolute basis and on a hedged basis. So, on an absolute basis we currently see sterling and the US as being more attractive. Europe has much lower yields, but spreads are fairly comparable.
Does further potential weakness in oil prices threaten high yield, given the relatively high proportion of energy companies in the asset class?
We have actually increased our weighting in energy this year, albeit in fairly conservative sub-sectors, such as refining, pipelines and exploration. We are underweight oil field service credits as this is the area that would be most negatively impacted if oil prices go lower, and that is certainly a risk given the increasing influence of shale producers.
When we allocate to energy, we want credits that are likely to be survivors if per-barrel oil prices go down into the high $30s. So if oil does ease, we should have limited or no exposure to stressed credits. If our view was that oil prices were going higher, we would be more aggressively positioned. If oil does rally, we expect to participate, but probably not as much as the broader market.
Where are the current sweet spots in in the market?
In terms of credit quality, we favor B-rated bonds as BBs are more sensitive to rises in interest rates and are likely to underperform when central banks increase rates. While we are neutral to underweight the CCC sector, this is where we find the most idiosyncratic opportunities.
In terms of sectors, we favor healthcare, metals and mining, technology and leisure; we are underweight wirelines, autos, banks and oil field services companies.
Even then, our positioning is based more on credit selection than prescriptive weightings. In metals and mining, our strongest calls are in precious metals; investing in low-cost producers that have the ability to withstand weaker prices.
In healthcare, which is a long-standing overweight, our view is that the sector won’t be negatively impacted by any threat of repeal of the Affordable Care Act in the US. We think it’s a tough piece of legislation for the Trump administration to amend or replace. The passing of the Act has been beneficial to healthcare companies for the most part because it brought more people under coverage.
How would you allocate capital into the high yield market currently?
One play would be to wait for the market correction that is likely over the next few months before investing. An alternative strategy would be to drip-feed assets into the market using the dollar-cost-averaging principle, before going in with a bigger allocation when a sell-off occurs. We believe any such sell-off is unlikely to be pronounced given the fairly healthy fundamental and technical factors underpinning the market on a 12-month view.
1 Source: Barclays Live, Barclays Global High Yield xCMBS & EMG index, as of July 31, 2017
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