For 2017, we have a very different outlook than going into 2016. We believe that rising Treasury yields will have an impact on high-yield bonds and that it will create more volatility for the asset class in 2017.
Looking back, 2016 was purely a momentum trade. It was highly technical and we saw credit spread tightening throughout the year, resulting in double-digit gains for broad high-yield indices.
In 2017, we expect that headlines and a changing political landscape may create volatility, and that Federal Reserve rate hikes may trigger some outflows from high-yield bonds. However, the health and fundamentals of the companies in the asset class look solid, and the pro-growth policies of the Trump administration may help the economy.
Also, it’s important to remember that rising interest rates are generally a good thing for high-yield companies because it indicates that there is growth in the economy. Similar to equities, high-yield bonds are more sensitive to the economy than interest rates.
We expect default rates to fall to the 2% to 2.5% range for high-yield, a bit below the historical average. Leverage is in line with the historical average, while interest coverage (a company’s ability to pay interest on debt) is at all-time highs.
Bottom line: The underlying fundamentals of high-yield bonds are still very strong. We think credit spreads will compress even more, which will offset rate increases to some extent, possibly to a large extent, in 2017
Kelley Baccei is a high yield portfolio manager at Eaton Vance