High Yield: Not Armageddon, but Hardly Paradise Either
With the economy stable, selected junk issues should continue to perform. But the big gains may have already occurred.
So are the good times likely to continue? Yes and no, analysts say. Most don’t expect prices to fall from here, and they see room for certain issues to rise further. But on the whole, they don’t expect the market to move much. The economy’s continued moderate growth provides support for the market but not enough to make it rise, they say.
The Bank of America Merrill Lynch High Yield Master II Option-Adjusted Spread index over Treasuries stood at 682 basis points on Thursday. That’s close to the 708 basis-point fair-value level calculated by veteran junk bond analyst Martin Fridson. His gauge is based on credit availability, industrial production, capacity utilization, the five-year Treasury yield and the default rate.
“Given how much the spread already has tightened, it would be a mistake to jump on the bandwagon in hopes of a strong rally,” says Fridson, chief investment officer at Lehmann Livian Fridson Advisors in New York. “If you’re just looking for income, it makes sense. I think it’s likely to level off and do okay.”
The BofA spread has shrunk 205 basis points from the four-year high of 887 points it reached February 11. Between February 11 and March 11, the BofA Merrill Lynch high-yield spread index returned 8 percent, which would be the third-best-performing calendar month in history, Fridson says.
Even market pessimists like Michael Contopoulos, head of high-yield strategy at BofA, say junk bonds were ripe for a rally. “Fears of a recession were way overblown in the first six weeks of the year,” he says. The economy expanded only 1 percent in the fourth quarter but is poised for growth of 1.9 percent in the first quarter, according to the Atlanta Federal Reserve’s forecasting model.
Central bank policy also is helping junk bonds. The Bank of Japan and European Central Bank have increased their easing efforts this year, and the Fed has indicated its next interest rate hike isn’t imminent. Meanwhile, oil prices have jumped about 50 percent since February 11.
Going forward, stable economic growth points to stable junk bond prices, Fridson says. “If the economy holds up, the high-yield market should hold up as well,” he says.
Whereas junk bonds obviously aren’t as attractive as they were six weeks ago, outside the commodities sector they’re still appealing, says Michael Collins, co-manager of the Prudential Total Return Bond Fund in Newark, New Jersey. “The Fed is dovish, and interest rates will stay low globally,” he says. “That should encourage a reach for yield.” The BofA Merrill Lynch high-yield spread index yields 8.29 percent, compared with 1.87 percent for the ten-year Treasury note. And the one-year expected global default rate stood at a modest 4.7 percent last month, according to Moody’s Investors Service, though that’s up from the current default rate of 3.7 percent.
Collins and his colleagues have been buying consumer sector bonds. “We’re optimistic on the consumer,” he says, citing gains in jobs, wages and home sales and lower gasoline prices. The problem, of course, is that’s a crowded trade, as many managers are flocking to the safest areas of the market. “That’s the challenge for managers,” Collins says. “That’s where credit research teams earn their money.” Although he can’t reveal his fund’s recent purchases, his team looks for companies with some problems but not enough to put them in the distressed part of the market. And the team goes for senior debt: secured bank loans. “In the worst-case scenario, you’re getting paid, and there could be good value,” Collins says.
He is also looking at “fallen angels” in the commodities sector. These are ten- or 30-year bonds of commodities companies that were issued at investment-grade and have fallen into junk. Metals miner Freeport-McMoRan, based in Phoenix, is “the classic poster child” for this, he says. “There are a slew of commodities companies moving into that area.” The fund seeks bigger companies that have the ability to sell assets. “It’s not for the faint of heart,” Collins says. “These bonds are falling knives.”
Not everyone sees value in the high-yield market. “We’re probably the most bearish strategists on the street,” says BofA’s Contopoulos. “We turned negative in September 2014, because we were at the end of the credit cycle.” And he sees no reason for a change in view now. “It’s been a steady decline with bear market rallies, and we think it’s the same this go-round as well.”
The fundamental picture hasn’t changed much over the past month, Contopoulos says. Manufacturing may be bottoming out, but at a low base, he notes. And his view of the consumer sector differs from that of Collins. Contopoulos points to the slide of retail sales in January and February as well as the rise in subprime auto loan defaults as signs of the sector’s weakness.
“For every small gain in manufacturing, it seems like there’s an opposite reaction from the consumer sector, which people are banking on to fuel the economy,” he says. Whereas BofA economists don’t expect a recession, growth both in the U.S. and globally remains a concern, the strategist says. He anticipates that the BofA Merrill Lynch high-yield spread index will generate a return of zero to –1 percent for the year as a whole, reversing a positive return of 3 percent so far this year.
So although market participants agree that prices won’t keep rising, as they have in the past six weeks, there is enough evidence to support a wide range of views as to where the market is headed.