Will the Rebound in High Yield Bonds Continue?

John Yovanovic, CFA
Head of High Yield Portfolio Management

21 February 2019

Last year was challenging for high yield bond investors. A generally volatile 2018 was capped by steep declines throughout the fourth quarter, with Bloomberg Barclays US Corporate High Yield Index tumbling 4.53% between 1 October and 31 December to end the year with a 2.08% loss. Fortunately, 2019 has gotten off to a much stronger start, with a large rebound that has recouped much of these losses. In January, the index rallied 4.52%, bringing spreads back to where they were in late November.

So what might investors expect looking ahead? Overall, we believe the high yield bond segment will continue to offer solid investment potential, even though it will likely face pockets of volatility in the shorter term.

Returns in January for High Yield Bonds and Loans Recoup December’s Losses

Returns in January for High Yield Bonds and Loans Recoup December’s Losses

Source: Bloomberg Barclays as of 31 January 2019.

What was behind the selloff?

The market gyrations of the past several months were never based on any real change in fundamentals for the high yield bond market. Last quarter’s high yield bond declines were part of a much broader selloff across all risk assets that was, at least initially, a reaction to a necessary repricing of equity multiples down as corporate earnings growth slowed. Investor fears of a widespread market retrenchment mounted as the risks of recession appeared to be rising on the Fed’s continued hawkish tone, slowing global growth, trade war talks, a possible no-deal Brexit, and continued US political chaos. As a result, almost all asset classes were sharply lower in December.

While most oversold markets then regained their footing in January, a number of issues could amplify volatility over the next few months as global economic growth continues to slow. With this mind, our 12-month outlook for the asset class remains constructive, but we are also closely looking at three important factors when evaluating the most attractive risk/reward opportunities:

  1. Fundamentals. High yield credit fundamentals generally remain solid, and spreads continue to be attractive versus other fixed income alternatives. There also does not appear to be anything that materially suggests excess in the market. Defaults remain relatively low compared with long-term historical norms, and average leverage remains in a range typical for the past several years. Company earnings outlooks are also mostly neutral to positive, if more cautious depending on how US-China trade talks ultimately progress.
  2. Future Fed actions. The Fed entered December on a hawkish note, worrying investors that it was being overly aggressive with its interest rate hikes and balance sheet runoff. However, it has taken a much more dovish tone so far in 2019, indicating it will be patient with further monetary tightening unless warranted by an uptick in growth or inflation. Although the Fed continues to see favorable growth and a strong labor market ahead, it also has acknowledged the risk increase for a less-favorable outlook – and the dovish tone in the year ahead could be favorable across US fixed income.
  3. Recession risk. We currently see relatively low odds for a US recession, though any notable deterioration in several macro risk factors could quickly change this view. One is US-China trade negotiations. Another is China’s slowing growth, but current indicators suggest the country will be able to navigate a soft landing as it did in 2015. And while Brexit could be a short-term volatility amplifier, we see it as less of a long-term concern, with no material threat to global GDP.

Looking ahead

Earnings season will provide important insight into companies’ financial health and the direction of the economy. The next few months should also provide greater clarity around trade tariffs, both in terms of how talks progress and the impact any final outcome may have on companies’ financials and growth prospects. Any potential market disruptions from these two issues could represent attractive buying opportunities for long-term investors.


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