Outlook 2016: Global High Yield
Continuing volatility and an elevated risk premium mean that high yield bond returns could be in the mid single-digit range in 2016, but we expect this performance to be attractive relative to many other fixed income alternatives.
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2016 will likely be another year when returns in the high yield bond1 sector are "coupon light" (i.e. total returns are lower than the coupons on offer).
Under our base case scenario, we expect a total return in the range of 4-5% for the global high yield index in 2016.2
Returns should be better for active managers and investors, who are able to take advantage of what we see as the likely continuing divergence of returns across issuers and industries.
Positive technical factors – such as modest supply, an uptick in demand, light dealer inventories, high cash balances at mutual funds, and more conservative positioning among high yield investors after the market correction in the second half of 2015 – could lead to a market bounce in the first half of 2016.
Several possible positive catalysts could emerge which would trigger a shift in sentiment and spark renewed investing interest by pension funds, insurance companies, and mutual fund investors.
The brunt of any rise in the default rate is likely to be weighted towards the end of 2016, which provides a time horizon for the high yield bond market to bounce back from what we considered to be somewhat oversold levels as 2015 came to a close.
Over the past two to three months, high yield strategists and investors have increased their expectations for defaults for 2016.
It is difficult to assess with absolute precision what the implied default rate is based on current market valuations - whether using yields or spreads for high yield bonds – because there have been changes in two variables at the same time.
Expectations for defaults in 2016, and the risk premium demanded by investors have both risen in recent months.
Indeed, a good portion of the recent widening of spreads in the high yield bond market represents this wider risk premium.3
This partially reflects the investor belief that they need a higher ‘illiquidity risk premium’ in order to be enticed to invest, since press coverage on the topic of poor and diminishing liquidity in corporate bond markets has been so high.
Default rates to rise but not as much as currently feared
Defaults4 should rise in 2016, but only moderately from the currently low level of defaults.
Defaults should be clustered in a handful of industries – primarily in metals & mining and energy, as well as in retail and media – where the market is already pricing in a high probability of default for a number of issuers.
The distressed debt5 ratio has risen after the late 2015 selloff; so the market is already pricing in a high probability of default for a larger portion of the index.
We believe that the global high yield market now looks relatively cheap after the spread6 widening during the second half of 2015. High yield valuations appear to be relatively cheap in several ways:
- Relative to the high yield market’s own valuations during historically analogous periods (at similar points in the credit cycle in past cycles, etc.).
- Relative to other asset classes: Versus investment grade credit, for investors who have the risk tolerance to bear greater potential volatility; versus emerging markets; versus government bonds; and versus cash & cash equivalents.
- Relative to predicted valuations from fundamentally-based forecasting models.
- Relative to our sense of the severity of potential further downside risk, and relative to the probability of positive catalysts emerging which could improve valuations over the course of the coming year.
Watch for key signposts as market conditions change during 2016
Rather than fixate on a total return forecast for the entire year, we believe that investors should instead focus on various signposts along the way to indicate whether the risk-reward profile of the high yield asset class is attractive or not.
As was highlighted clearly in 2015, the market can rally for several months at a pace that is unsustainable for the full year. The market can also become oversold. We believe that key market trends to monitor include the following:
- The pace of M&A activity: We expect that merger & acquisition activity will remain elevated and that many high yield companies will continue to benefit from larger, higher-rated issuers pursuing strategic mergers as they seek growth opportunities.
- The trajectory of oil and natural gas prices: We expect a recovery in oil prices to be delayed until the second half of 2016, given recent shale production and oil supply data.
- The pace of fallen angels: We expect the pace of investment grade companies being downgraded to high yield to rise, particularly in troubled sectors, versus rising stars. We also expect the pace of distressed debt exchanges and defaults to increase.
- The pace and mix of supply: We expect gross new issuance will likely be slightly lower in 2016 than in 2015 and may be split between refinancing activity and M&A financing, with very little for financing highly levered buyouts.
- Demand reversals: Extremes in mutual fund flows can often be contrarian signals as widespread mutual fund redemptions are often concurrent with market corrections.
- The pace of Federal Reserve (Fed) rate hikes: Investors currently expect fewer rate hikes in 2016 than the Fed itself is projecting.
- Changes in the strength of regional economic growth across the Americas, Asia and Europe.
Many of the themes that we expect to dominate in 2016 are similar to those in 2015, but perhaps the most important strategic calls in 2016 will surround the decisions about when to add exposure in energy and emerging markets, as sentiment about both market segments is nearly universally negative as the year begins yet valuations backed up materially in late 2015.
High yield bonds could provide positive returns even as the Fed hikes rates
The Fed raised the Fed funds rate by 25 bps in December, representing the first rate hike in more than nine years by the US central bank.
Many investors hold the view that fixed income returns will inherently be negative during a period when the Fed is raising short-term rates, but an analysis of the three most recent Fed rate hiking cycles shows that this is not the case.
In fact, an analysis of the past three rate hike cycles shows that high yield bonds can produce positive returns over a six month or 12-month horizon after the Fed first raises the Fed funds rate.7
High yield can also outperform other fixed income asset classes, such as Treasuries and investment grade corporate bonds.
This was especially the case during the 2004-2006 rate hike cycle but was also generally the case in the 1994-95 and 1999-2000 rate hike cycles.
We believe that prospective returns in corporate bonds markets in 2016 could be much better than recent performance, and better than the bearish consensus view that seems to have developed over the past couple of months.
While many uncertainties remain as 2016 begins, the risk premium embedded in high yield valuations is high. There are several signposts that we will be monitoring in the market to potentially become more constructive as the year progresses.
Fundamental research and active risk management in the face of changing market conditions will continue to be key to outperformance.
1. Investment grade bonds are the highest quality bonds as assessed by a credit ratings agency. To be deemed investment grade, a bond must have a credit rating of at least BBB (Standard& Poor's) or Baa3 (Moody's). A high yield bond is a speculative bond with a credit rating below investment grade. Generally, the higher the risk of default by the bond issuer, the greater the interest or coupon.↩
2. Referencing the Barclays Global High Yield ex-CMBS ex-EMG 2% Issuer Capped Bond Index.↩
3. Risk premium is the extra return over cash that an investor expects to earn as compensation for owning an investment that is not risk free, so its value could go down as well as up. There are some risk premia where the extra return expected is over and above the return earned from another risk premium.↩
4. Default riskThe risk that a bond issuer will not be able to meet their debt payments and subsequently default on their contractual obligation to investors.↩
5. A distressed asset is one that is put on sale, usually at a cheap price, because its owner is forced to sell it. There could be various reasons for this, including bankruptcy, excessive debt and regulatory constraints. Debt itself can be sold on to a new owner at below face value (distressed debt).↩
6. Yield spread is the difference in yield between different types of bonds (for example, between government bonds and corporate bonds).↩
7. Source: Schroders↩