Head - Fixed Income Strategy
April 30, 2018
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US high yield returns are near flat for the year
Performance in US high yield corporates continues to reflect greater investor concerns over rising interest rates, not default risks. With the 10-year Treasury yield reaching its highest level since 2011, long-dated yields are nearly 100 basis points (bp) higher over the last 8 months. This has had a greater impact on higher quality, investment grade (IG) assets. Indeed, US aggregate IG benchmarks have now fallen 2.5% year to date, with IG corporate bonds declining over 3.5%. Conversely, US HY returns are near flat for the year, with the lowest rated HY issuers (CCC-rated) managing to gain 1.0%, outperforming both IG bonds and US equity markets
The appetite for risk had been apparent in recent new deals from WeWork (rated Caa1 by Moody’s) and Jagged Peak Energy (rated B3 by Moody’s), which received orders 3 to 5 times the amount originally offered. To us, this is a clear sign that credit concerns are less worrisome over the near-term as the US economy benefits from corporate tax cuts. Though nearly $2.5 billion of outflows from bond mutual funds and ETFs were reported the week ending April 26, April was the first positive inflow month since October 2017.
Though US markets are rapidly evolving post-QE, we think US HY should continue to benefit from a supportive global growth outlook, 20%+ 1Q18 EPS growth, declining net supply and low defaults. Indeed, the US HY default rate at 3.3% (or 2.6% ex-energy) is well below the historical average. More important, benchmark yields above 6.0% (9.0% for CCC-rated HY) remains an attractive coupon versus the global aggregate, which comes in around 2.0%. If Treasury rates should rise further, higher coupons and wider spreads in US HY are likely to provide better insulation relative to IG credit.
The US HY bank loan market has also outperformed this year, with the S&P leverage loan index gaining 1.4% year to date. Again, with fundamental issues less concerning, investors are more focused on the rise in LIBOR and rising expectations for future rate hikes by the Federal Reserve. Indeed, the US Fed expects to raise rates twice more in 2018, and three more times in 2019. In our view, 25bp hikes each quarter should not be ruled out, as long as financial conditions don’t deteriorate meaningfully. This would bring the Fed Funds rate to 3.5% by the end of 2019, with 3-month LIBOR following along. In turn, this will keep the demand for floating rate assets high, benefitting the HY bank loan market.
However, we do take notice of the technical impacts driving up LIBOR rates and how it may influence bank loan performance. Specifically, the widening in 3-month/1-month LIBOR spreads. In some cases, when the basis between these two rates widens, issuers can switch the underlying base rate to the lower yielding option. In turn, producing a lower cash flow. While we don’t think this will be a catalyst for future outflows, switching to a lower underlying benchmark rate can certainly mitigate potential performance.
That said, HY bank loan LIBOR spreads around L+370bp still offer value, in our view. Whether spread off 1-month or 3-month LIBOR, HY bank loans all-in yield is still attractive. Especially when compared to higher quality BB-rated HY bonds