PMC Weekly Review - March 23, 2018
In its annual communique, the G-20 group of finance ministers and central bankers from the world’s largest economies observed that the bloc is experiencing “the broadest synchronised global growth upsurge since 2010, and a pick-up in investment and trade.” At the same time, the United States is putting its foot on the fiscal gas pedal, and consumer and business confidence surveys are at post-crisis highs. At first glance, this appears to be the exact type of market environment best suited for risky assets like junk bonds. However, with the end of the first quarter quickly approaching, high yield bonds are in the red year-to-date, and many investors are dumping their junk. What, then, could be driving the most recent pullback in this asset class, and what kind of ride might investors expect from here?
The answer to the first question is simple—rising benchmark interest rates. Following the Federal Open Market Committee (FOMC’s) meeting this week, the Federal Reserve (Fed) is now targeting the fed funds rate at 1.50% to 1.75%. Although the central bank’s march toward tighter monetary conditions has untethered short-term bond yields from zero, recent tax cuts and higher spending caps are leading to a surge in Treasury issuance. These developments, along with expectations of marginally higher growth and inflation, have shifted the Treasury yield curve higher. Within the investment industry, high yield bonds are known to outperform both higher-rated corporate bonds and Treasurys in rising rate environments, due to their greater yield cushion, or spread, over these higher-quality instruments. In fairness, the only domestic fixed income sector (barring Treasury bills) that has done better than high yield bonds this year is bank loans, which are often issued by the same firms, but have floating coupons. Considering relative performance, high yield has done pretty well so far this year, but comforting ourselves by assuming we can expect more of the same would be to ignore an inauspicious set of current circumstances and even more dark clouds on the horizon.
The current situation features tight valuations in the high yield bond market, which have approached levels last seen before the selloff in commodity-related bonds in 2014 and 2015. The option-adjusted spread (OAS) on the Bloomberg Barclays High Yield Corporate Index stood at 3.38% on March 21—well below the 4.61% median for this figure since 1994. This tells us that the incremental benefit from holding junk bonds over similar-maturity Treasurys has been lower for only a very brief period in mid2014 and in the run-up to the Great Financial Crisis. Further, JPMorgan notes that the share of index constituents trading with a spread of fewer than 250 basis points has reached nearly 44% as of the end of January. The last time the figure was higher was in 2007. For comparison, this measure fell just shy of 21% in June 2014. Consequently, very little upside remains for the asset class even if today’s solid fundamentals were to improve, and history shows that the most likely road from such rich valuations is bumpy and painful in the short to medium term.
The aforementioned clouds represent the potential for higher interest rates, which would mean higher debt service costs for lowrated borrowers. The recent spike in the LIBOR-overnight indexed swap spread (LOIS) indicates that short-term credit conditions have tightened at the same time that Treasury yields have risen. However, rising interest rates are a risk we can easily quantify, and many more looming threats exist that could cast sizable wrenches into the smooth functioning of the high yield market and the American economy writ large. Foremost among these would be a trade war with our major commercial partners, but domestic political turmoil, a drop in commodity prices, tension in the South China Sea, or further sabre rattling with North Korea could also cause investors’ appetite for risk to dry up. Many investors have already headed for the doors—high yield mutual funds have experienced five straight months of outflows, and more than $11 billion in 2018 through February, according to Morningstar. It is entirely possible that America’s speculative debt will keep chugging along in 2018, and investors will fall back in love with their junk. However, the market is priced to perfection, as they say, and expectations for corporate America are high. It would not necessarily take a major political crisis to push spreads wider from their current tights. Missed earnings estimates, a series of defaults, or even continued outflows could make the ride quite a bit rougher for those who stay the course. When high yield bonds were last discussed in January 2017, we noted that high yield investors would be wise not to expect returns in line with 2016 for the coming 12 months. Now that we are being paid even less to take junk credit risk, we suggest that investors equip their portfolios with a good pair of shock absorbers, because the road in 2018 is likely to be bumpy.