High yield is over-crowded, and there is nothing to gain any longer by being invested. Is this the case?
How will high yield react in the case of rising interest rates?
The question that should be asked is, “Are we at the end of a five year bull market in corporate bonds or at the beginning of an era of lower rates?”
A five year historic view dictates that it may be time to take profits and focus on capital preservation in mainstream high yield markets. A historic or 20 year forward-looking view may indicate that rates are reasonable where they are, if you agree with Signet’s thesis of an extended period of low rates to come.
Signet agrees that investors are right about the low yields in high yield markets, high yield bonds have outperformed since the 2008-9 crisis. But the consensus of investors may not be right – that because interest rates are low, they must invariably rise soon and in a damaging fashion. In addition, there are different ways to invest in high yield and the answer, as always, lies in the details.
Why are rates so low and why does Signet expects them to stay low?
The main reason for the fall in yields is of course the enormous levels of indebtedness in developed world economies. And for the first time in a 200+ year investment history, there are worsening demographics to support economic growth (growth = working population growth + productivity growth). Very heavy government liabilities and private debt, which helped fund growth in the last 30 years, is now a heavy burden to bear with flat or reduced incomes. Unfortunately, demographics can be expected to worsen in the coming decades, not improve. As a result, worldwide central banks have pushed interest levels down to record lows in order to relieve the debt burden and maintain prosperity (e.g. housing and equity prices). And deleveraging will take time and will need very low yields. So expect asset returns to remain low (and less volatile). Signet posits that we have entered an extended era of low rates and significant demand for yield by an aging baby boom population. We expect 3-4% for investment grade bonds, stocks to yield 4-5%, specialist HY to yield 6-8% over at least the next 3-5 years. We favor specialist credit with moderate duration as a risk strategy.
Our argument remains as follows. The developed world’s debt levels remain enormous (public and private). A cyclical expansion is underway but economic growth remains lackluster even with extraordinary central banks support. Price data shows no pressure on inflation, even deflationary tendencies, due to the heaviness of indebted economies (especially in western and peripheral Europe, Japan and smaller aging societies like Korea and Taiwan). Demographic issues are far from being over, indeed are currently worsening. In this regard, we have to agree with the logic of PIMCO’s view of the “New Neutral” (see attached).
With the demand for yield so strong, mainstream HY is, of course, yielding less and that is the concern; a) investors don’t earn enough and b) the consensus worry is that rates will rise and lower-yielding bonds will be less desirable.
Unfortunately the search for yield should keep rates low for years. History has taught us that periods of extreme indebtedness can only disappear on a secular basis (say over 10-25 years). Following periods of historic extreme indebtedness (this being by far the worst due to modern finance), interest rates necessarily fell or stayed low for decades (e.g. US Civil War 1860-64, Great Depression, WWII, Japan) or countries suffered depression. We must also note that if Fed Funds rates start to rise in Q2’15 as consensus expects, they should rise from 0% to 0.25% and possibly reach a top of only 2% by 2017 in a mildly healthier economy in the US. Investors must note that structural trends towards rising rates take many years to emerge and decades to play out. We expect lower rates for longer than almost anyone believes today. The pressure on indebted societies would quickly cause another “Lehman moment”, deflation and huge pressure on private and public balance sheets, which should cause subsequent recession and pressure on rates to fall again. Will there be tightening interest rate cycle? Yes, of course, but not a strong one.
Specialist well-researched and focused HY portfolios are generating c. 6-8% current yields while mainstream large HY is generating 1-2% less.
Six to eight percent yields with reasonably short duration offer a lot of rate protection. Specialist credit managers tend not to be exposed to the crowded mainstream segment of the HY market. If there are outflows from bonds in general (like in June 2013 and now), portfolios will inevitably fall in value due to some disinvestment, there is no magic. But these bonds produce desirably high yields and can be expected to mature at 100, par, or be driven up by a well-researched catalyst. Focus on companies that are not covered by the large credit houses, also enable managers to generate additional gains due to pricing inefficiencies and capital structure events that unlock value, such as refinancings, takeovers, rating upgrades etc. Investing in these types of situations makes portfolios somewhat less correlated to the overall HY market, since credit spreads and interest rates are not the main drivers of the underlying bond prices.
From a technical perspective, the summer months are always more quiet as investors go on holiday. It is therefore not unusual for HY markets to consolidate somewhat, particularly after the gains that have been enjoyed. But profit-taking enables managers to find new opportunities with more attractive yields and lower pricing.
In a forward looking era of low rates, we expect that capturing larger yields through well-researched credit portfolios should be a winning strategy for years to come.