5 Reasons Investors Might Not Want to Turn Risk Off Just Yet

June 16, 2016

Andrew Jessop

Elizabeth MacLean

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Prices on high-yield bonds and leveraged loans are up sharply from the lows hit in February, prompting some concerns that there is more risk, rather than value, in this corner of the fixed-income market.

But with interest rates globally so low — even negative in some parts of the world — and the U.S. economy unlikely to enter a recession anytime soon, discerning investors can still find value and income opportunities in segments of the high-yield bond and leveraged-loan markets over the near term.

Here are five factors that could support leveraged-finance markets in the months ahead:

Low defaults. The much-publicized troubles in the energy sector could push the overall U.S. default rate above 5 percent over the next year, the highest level since the late-2000s financial crisis. Yet in 2015, 75 percent of defaults occurred in one sector: commodities, where low oil prices have wreaked havoc. Year-to-date, that ratio trends even higher. Excluding commodities, the default rate has been running below 2 percent, just a fraction of the long-term historical average. We expect this benign environment to last for at least the next 12 to 18 months.

Healthy businesses. Consumer and service sectors not tied to commodities remain attractive, with healthy growth in revenues and earnings. Moreover, savings at the gas pump mean that U.S. consumers have more money to spend on other goods and services. And whereas U.S. economic growth has slowed, we don’t expect a recession anytime soon.

Fallen angels are bruised but not beaten. Companies known as “ fallen angels” — those that were recently downgraded from investment-grade to speculative-grade — may be in better shape than investors think. First, well over half of the companies that saw their rates slashed to junk are in the energy, metals and mining sectors. Second, large companies that had enjoyed an investment-grade rating tend to have more flexibility to refinance their debt and push out maturities, improving their liquidity position in the process. In some cases, these firms have better access to the equity markets or are able to raise capital via asset sales to pay down debt.

Higher returns, less volatility. High-yield bonds are still compelling, even given the strong rally that began in February. Yields, now hovering in the mid–7 percent range (or high–6 percent range, when excluding commodities), are certainly down from the high-water mark of 10 percent in February. But when 30 percent of government bonds across the globe are yielding negative rates, these kinds of returns are still very attractive for investors looking for income and able to take on additional risk. Moreover, investors in high-yield have the potential of receiving equitylike returns with less volatility than the stomach-churning volatility characteristic of the stock market. High-yield bond volatility has been historically about half that of the equity market. It’s even less in the loan market, for which volatility on a five-year trailing basis is nearly half that of high-yield bonds, albeit at marginally lower yields.

Diversification. Leveraged loans, which are higher in the capital structure and thus less prone to potential losses than more junior debt, should a firm restructure its debt, can offer strong diversification benefits from the broader fixed-income and equity markets. Foremost, rates on loans are floating, which means they rise and fall in tandem with their benchmark rate and therefore carry negligible interest rate risk. This aspect can be particularly attractive as investors look for ways to help protect their portfolio when rates rise. When investors are convinced that the Federal Reserve rate-hiking cycle is under way, demand for loans is likely to increase.

To be sure, finding value has grown more challenging from earlier this year, and over the next three to five years, there’s a real risk that global central bank policy will become less effective in supporting economic growth. We expect demand to continue, as investors around the globe look for income and investments that diversify their portfolio in a low-rate investing world. At the same time, investors will also need to focus longer term on capital preservation and on companies that have not become overly dependent on the easy money that central banks have injected into financial markets since the crisis.

Andrew Jessop is a managing director and high-yield portfolio manager, and Elizabeth MacLean is an executive vice president and bank loan portfolio manager; both at Pacific Investment Management Co.’s headquarters in Newport Beach, California.

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