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2016 was a very strong year for global high yield. Spreads tightened from 650 basis points to 400 basis points. The total return for the asset class was 15.0%, making it the best performing fixed income asset class in 2016. Out outlook for 2017 is more conservative, especially since we are so late in the credit cycle already.
2016 was a typical mean-reversion year. The laggards of 2015, US high yield, CCC-rated bonds, Energy, and Metals & Mining, were the star performers of 2016. The first two months of 2016 were difficult for high yield. However, as oil bounced and global growth concerns abated, high yield rallied for the remainder of the year. Comparing currencies, euros returned 10.3% and US dollars 16.2%.
Compared with a five-year average, high yield trades at 0.8 times the average index spread. Over a 10-year horizon, the multiple drops to 0.7x. Using this valuation measure, high yield spreads are looking expensive. On the other hand, high yield can trade at levels perceived to be expensive for a long time. Comparing the asset class’ current yield with other fixed income classes is another way to determine its relative attractiveness. At a 5.6% current yield, high yield does not look too bad at all at the start of 2017.
The US typically trades wider in spread terms than the EU. After the Trump rally this is hardly the case. US high yield should trade wider because of its lower-rating, higher-duration tilt towards riskier sectors like Energy and Metals & Mining (20% index weight). If we adjust for these differences, we see that EU high yield trades wider than the US.
From a valuation perspective euro-denominated bonds therefore look more appealing than US-denominated bonds. We have an overweight in EU high yield against US high yield on the back of valuation, but also because we do not see late-cycle behavior in Europe. Balance sheets are healthier, with much lower leverage. Furthermore, monetary tightening is happening in the US, while in Europe we continue to see monetary easing, creating a low-yield environment. The significant rate differential between the two regions is more in favor of European companies.
Another important point to highlight for the coming period is that high yield is not very sensitive to changes in the interest rate. The interest rate duration is only about four years and due to negative correlation between yields and spreads the actual sensitivity is even lower. High yield can perform positively in a rising rate environment. The asset class has more difficulties when there are sudden shocks in underlying rates. There is a chance that this might happen in 2017, since the Fed has to hike rates rather late in the cycle with the average quality of US corporates already deteriorating.
We have become more constructive on the US economy as a whole. We believe that Trump can have a positive impact on US GDP growth, which mainly benefits US consumers. We also deem a recession in 2017 less likely now, but there is greater risk of the US economy going into an overheated situation, which can lead to a recession in two years’ time.
We remain very cautious on US high yield companies. Leverage, on average, is too high, approaching the peak-levels of 2001. Many companies continue to show late-cycle behavior (more debt funded M&A, increased shareholder focus, etc.) which impacts underlying balance sheets. There is additional risk that the Fed is going to be more hawkish and will start to hike more aggressively. Eventually this could lead to refinancing risks, in particular for highly leveraged companies (CCCs). This is not priced in at the moment.
On European high yield we are more positive. Corporate balance sheets are healthier, leverage is lower and M&A activity is more muted. European economies are doing fine and unemployment is finally coming down. We are overweight European high yield.
We are underweight US high yield, CCCs and leveraged sectors such as Telecommunications, Pharmaceuticals and Energy. Sectors we still overweight are mainly the sectors that heavily depend on the American and European consumer. Consumer Cyclicals (retailers, restaurants, lodging), Food & Beverage, Packaging, Automotive (suppliers), have on average lower leverage, and should perform relatively well, especially in a possible boom-bust scenario for the coming two years. In addition we stick to our overweight in off-benchmark European banks and insurance companies because of strong capital / solvency ratios and attractive spread compensation.
One of the major drivers of last year was loose monetary policy across the globe. Up until now central banks have added almost USD 200 billion a month to the monetary base. As a result a big proportion of the market was trading at negative yields. This pushed many investors into investment grade and high yield markets. With the announcement of a reduction in the Quantitative Easing (QE) program in Europe last December, the risk of more tapering has increased. This means that somewhere in late 2017, total worldwide QE purchases will start to decline. This changes the game plan.
Trump’s election will extend the credit and economic cycles. It will cause increasing imbalances, including corporates that are releveraging like never before. The risk is a recession that will be deeper but later than expected. To the extent it causes more Fed action than anticipated by the market, it will cause volatility.
The exposure to European high yield fits nicely as this market is far less exposed to the risk of yields moving up further. Overall we do see opportunities and pockets of value in global high yield, but remain conservatively positioned, steering our credit beta very close to 1. We strongly believe that winning by not losing remains key, especially since we are so late in the credit cycle already.