Why high yield can avoid first-ever successive annual slump
Neuberger Berman High Yield Bond Fund portfolio manager Thomas O’Reilly explains why he remains optimistic on US high yield bonds.
While high yield volatility is likely to remain elevated from global economic weakness and stock market turbulence, we are still constructive on the market this year.
Even though 20% of US high yield is in the challenged energy and commodity-related sectors, the other 80% of the market is in significantly better shape.
High yield valuations, excluding the commodity areas, are compensating investors for default risk. The yield-to-worst for the overall high yield market is 9.1% – but it is 7.8% excluding energy and commodities, still a spread of 648 basis points (as at 29 February 2016).
The default rate was 1.8% last year and has been under 3% for six years, but this could approach 6% in 2016 and 2017.
But again, it will likely be concentrated in the energy and commodity spaces. We do not expect a significant uptick in defaults in the other areas of the market.
Biased towards stability
We are significantly underweight energy and expect oil to be longer for lower, so we are likely to remain positioned this way for some time.
There is one sub-sector within energy we do hold as an overweight, gas distribution, which is primarily made up of BB-rated gas pipeline businesses much less sensitive to commodity prices than the E&P names.
We are underweight to lower quality issuers, which means we are overweight BB-rated debt and above.
In 2015, the US High Yield Master II Constrained Index fell by 4.6%, but BB-rated debt was just 1% lower, while CCC-rated debt plunged 15%. It has not paid to be in the lower quality tiers in high yield.
Therefore, we favour the more stable, non-commodity and non-cyclical areas of the high yield market. We are overweight casinos, which have benefitted as consumers have received a dividend from the lower prices at the gas pump.
We are also overweight healthcare, which has certainly benefitted from the Affordable Care Act as more people have become insured. Healthcare also includes the pharmaceutical companies, which offer strong and sustainable cash flows.
Expect spread tightening
We have never had two successive annual declines in the US high yield market. This does not mean it cannot happen, but it would be unusual.
Despite US growth moderating recently, we believe the economy has enough momentum to keep expanding as the year progresses, albeit at a moderate pace.
We also expect inflation to remain relatively modest and the Fed to be very gradual in its tightening cycle.
While it is difficult to time the market in high yield, we still believe 2016 and 2017 will offer attractive returns for investors in US high yield, particularly following the negative returns in 2015 and so far this year.
We expect spread tightening in most high yield sectors outside of commodities in 2016, generating a total return of 5-8% for the asset class.