High yield bonds have had a reasonably strong start to the year, particularly considering the fallout within the equity markets. For example, in January, the S&P 500, the index of leading shares in the US was down 3.5% over the month. In contrast, US high yield bonds, as represented by the BofA Merrill Lynch US High Yield Master II Total Return Index have returned 0.7% in US dollar terms.
A similar phenomenon exists in Europe where the MSCI Europe Total Return Index is down 1.8% in euro terms versus a rise of 1.0% in the BofA Merrill Lynch European Currency High Yield Total Return Index.
Driving the positive performance in high yield has been the decline in yields on core government bonds. Bond prices move inversely to directional moves in yields, so when yields fall, prices rise. The yield on the 5-year US Treasury fell more than 20 basis points in January whilst the yield on the 10-year US Treasury fell more than 30 basis points. This is important for the high yield markets because this is the maturity part of the yield curve around which high yield securities are priced.
The other major influence on bond prices is credit risk: this reflects individual corporate strengths together with broader macroeconomic forces on an issuer’s capacity to meet their repayment obligations to bondholders. There is a danger that investors may extrapolate the recent weakness in some of the economic data statistics such as the soft non-farm payrolls growth in the US as less an aberration (related to harsh winter weather) and more of a turning point signalling loss of economic momentum. Our view is that the temporary weakness in developed market economic data will abate.
More concerning has been the weakness in emerging markets where slower Chinese growth and volatility in emerging asset prices (partly due to liquidity draining from emerging markets in response to the US Federal Reserve tapering its asset purchases) has led to negative sentiment towards emerging market debt and equities.
So far, the emerging market fallout has not led to contagion to credit markets, although there have been outflows from Exchange Traded Funds (ETF). In the past, we have seen that during bouts of volatility, the ETF market has been a lot more closely correlated with equity markets than the cash bond high yield market.
This suits us because we are primarily invested in cash bonds from developed market issuers. In fact, fund flows support the notion that in volatile times, investor preference is for bonds over equities. The global mutual fund data flows from BoA Merrill Lynch for the first five weeks of 2014 show an outflow from equity funds and positive flows into bond funds, with government bonds, investment grade corporates and high yield all benefiting. The exception is emerging market debt, which remains in outflow.
Flows can be notoriously volatile, however, and our focus is on the cues that drive medium to long-term performance – valuations, fundamentals and liquidity. On all three factors, we believe the outlook for high yield bonds remains fair.
Valuations within high yield remain attractive. On a historical basis, metrics are marginally rich but only slightly above historical averages. On a relative basis, high yield bonds continue to look inexpensive when yield spreads are set against government bonds, investment grade bonds and expected default rates.
At the fundamental level, corporate earnings have been good. By 12 February 2014, almost 76% of S&P 500 companies that had announced earnings in the most recent reporting season had beaten expectations and the companies we talk to are generally upbeat. What we do not want to see, however, is optimism spilling over into shareholder-friendly/bondholder-unfriendly corporate behaviour. We have noticed, particularly in the US, which is at a more advanced stage in the economic cycle to Europe, a tick-up in more aggressive uses of high yield issuance proceeds, such as for acquisitions. However, as the chart shows more aggressive uses of proceeds (red shadings) are still far below the danger levels of 2005-7.
Source: Morgan Stanley, 6 February 2014
In terms of liquidity, the outlook remains encouraging. There is approximately US$25 billion of new US high yield issuance in February and that calendar is spread across bonds of different sizes, industries and credit ratings. Such breadth is usually a sign of a healthy market.
For now, our expectations are unchanged that global high yield can generate mid-single digit total returns in 2014, although the strength of that figure will depend on the quality of security selection. For our part, we continue to favour single B and CCC high yield bonds, and some of the smaller issuers where we believe fundamental research is able to identify value.
Kevin Loome, co-manager of the Henderson Horizon Global High Yield Bond Fund