PMC Weekly Review - January 13, 2017
Despite a dismal start to the year, investors who owned high yield bonds throughout 2016 were rewarded with equity-like returns of over 17%, as measured by the Bloomberg Barclays U.S. High Yield Corporate Bond Index. Such strong performance, especially in the land of fixed income, is clearly a cause for celebration. Although we have no intention of discouraging Champagne popping, it is important to understand what drove 2016’s returns, examine how durable those drivers are, and determine what sort of market we can expect in 2017. After taking these considerations into account, it is likely a mistake to expect similar returns in the coming year.
The answer to the first question essentially boils down to oil prices, as a substantial portion of the high yield market comprises the debt of energy and commodity-related firms, and the shifting demand dynamic for junk bonds. This time last year was pretty dismal for the asset class, which ultimately booked its worst January performance in at least 20 years. Brent and WTI crude had reached their nadir, with prices below $30 per barrel mid-month, and investors feared a wave of defaults from the beleaguered Energy sector and the metals & mining industry. US high yield mutual funds had net outflows of over $8.5 billion in Q4 2015, and lost another $3 billion in January. The disheartening atmosphere was reflected in yields and spreads that were the highest and widest that they had been since the European sovereign debt crisis.
However, February suddenly brought a sunnier picture, when oil prices began to rebound and continued to appreciate through the end of the year. The trend was boosted when December brought a welcome surprise for energy firms, as an unprecedented agreement between OPEC and Russia helped to push oil prices over $50 per barrel. Although the majority of defaults in 2016 came from commodity-related sectors, climbing oil prices helped keep broad market defaults to approximately 4% for the trailing twelve months. Consequently, the average yield on junk bonds began a precipitous decline, followed by only brief halts when Brexit and the surprise election of Donald Trump occurred. The positive fundamental backdrop was bolstered by the largest calendar year of net inflows since 2012 and a 5% decline in issuance relative to 2015, according to J.P. Morgan data.
Whereas 2016 ended on a rosy note, there are justifiable concerns that the favorable backdrop for sub-investment grade credit may not last. Most importantly, oil prices may not continue to trade in their current range, which they reached in no small part due to the positive sentiment associated with the headline-making OPEC-Russia production cuts. Although the deal grabbed the world’s attention, the agreement amounts to just a 2% cut in global oil production, and to what extent participants will respect the production cut agreement is unclear. In addition, if the cuts are successful and prices rise further, US shale producers stand to be the new global swing producers when higher-cost domestic basins once again become profitable. This matters for high yield, where energy sector spreads are again trading in-line with the broad market, implying crude prices of $90 per barrel. Beyond the likely quota-busting within and without OPEC, the prospect of infrastructure spending, lower taxes, and, consequently, more government debt (and higher benchmark yields) in the US all point to a stronger US dollar. A stronger dollar would prove bearish for oil prices, and higher Treasury yields would make it more expensive for energy firms to refinance existing debt.
Although oil and defaults at energy-related companies have dominated the discussion of fundamentals in the high yield space in 2016, and are not likely to shift far from center stage in 2017, this year will likely bring about a refreshingly broader discussion of what constitutes the fundamental underpinnings of the asset class. Healthcare and pharmaceutical issuers are facing headwinds, from either proposed changes to or the outright repeal of the Affordable Care Act (ACA), coupled with potential policy responses to soaring drug prices. Retailers are hurting from declining traffic, as shopping continues to shift to online competitors. Even though trouble in Healthcare and the Consumer Discretionary sectors could lead to localized increases in defaults, J.P. Morgan forecasts that the drop in energy-related defaults will keep broad-market defaults below their historical average of approximately 3.9% in 2017.
For now, most managers we cover have a positive view of the domestic high yield asset class, noting that most of the market has stable or improving leverage and debt service coverage ratios and some of the highest yields in the developed world. This last fact alone is likely to keep investors’ pocket books open to high yield firms that want to borrow, and most asset managers believe the junk bond still has room to run, although some are circumspect in their approach to commodity-related issuers and other troubled portions of the market. Junk bond returns so far this year have validated this view and may continue to do so well into 2017. However, it’s worth remembering that 2016 began with high yield spreads well wide of the historical median. This year started with option-adjusted spreads below the median, meaning the upside for investors is substantially diminished. There’s no need to put away the Champagne, but it might not make sense to restock your supply just yet.
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