Head - Fixed Income Strategy
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Despite a recent reduction to our US High Yield allocation, we still see potential opportunities here and elsewhere within High Yield Fixed Income.
After a strong start to the year, US High Yield (HY) bonds faced a slight correction in March as crude oil prices dropped 13% in the first two weeks of the month on oversupply issues. HY benchmarks lost 50% of their year-to-date (YTD) returns, as the energy sector declined 3.0%. Markets have since recovered, with oil prices moving back into the low $50’s/barrel and HY bonds retracing almost all of their losses. Despite the volatility, US HY bonds have still managed to gain 2.6% YTD.
Yields and spreads are generally unchanged since our last report in April. Index spreads are roughly 380bp or 60bp above their post-crisis tights, while yields are around 5.8% and remain 100bp above 2014’s all-time low. Valuations in US HY bonds are well through historical averages and look unattractive. Yield ratios versus US investment grade corporates have also fallen, as investors cross-over into HY for additional yield pick-up. This was collectively why Citi Private Bank’s Global Investment Committee decided to reduce some of its overweight to US HY bonds last month, still maintaining a slight overweight.
While valuations are tight, fundamentals remain supportive. Bond issuance has been robust, though 75% of all new deals have been used to refinance existing debt. This is likely to put less pressure on upcoming maturities, with the proverbial “maturity wall” being pushed further out. Higher earnings have stabilized rising leverage trends, and the oil recovery should lessen defaults in the energy sector. In fact, US default rates have dropped for the second consecutive month, currently 4.1% (down from 4.4% in February and 5.1% in December).
US HY variable-rate bank loans. Despite the pullback on our HY bond overweights, we maintain our high conviction in the variable-rate HY bank loan space. As expected, HY loan performance has trailed behind HY bonds this year (+1.2% versus 2.9%, respectively). However, bank loan prices have also exhibited significantly less volatility. This was on full display last month, as the correction in oil prices did not impact HY loan returns at all, while HY bonds lost 50% of their YTD return.
We recognize that prices in HY loans have risen substantially, with roughly 70% of the entire market now trading above par. Issuers have been taking advantage by refinancing existing debt into loans with more favorable terms (or lower spreads). While this is a headwind to future performance, we also recognize that LIBOR rates are rising. With 3-month US LIBOR now at 1.15% (above most LIBOR floors), and projected to trend toward 2.0% over the next 12-months, this should help offset some of the decline in coupon spread. In our view, the HY loan market should be viewed as an attractive yield alternative, which should benefit from rising short-term rates, a strong fundamental outlook in credit and significantly lower price volatility.
European HY has gained roughly 2.0% YTD, and was only slightly impacted by the correction in oil prices last month. Indeed, euro HY markets have little exposure to the energy sector. A solid pick-up in new issuance has been easily met by strong demand, as ECB QE continues to herd investors towards the higher yielding HY market. We have some growing caution as the ECB begins to taper monthly purchases, though we’d still expect spread volatility to remain under wraps in the near-term.
Our preferred investment in Euro HY is through bank loans. Similar to the US loan market, these securities offer floating rate coupons and are higher in capital structure. More importantly, yields are more attractive (~5.0%) than those of euro HY bonds. This premium reflects the European senior loan market’s relatively smaller size and lesser accessibility. YTD, European loans have gained 1.1%, trailing euro HY bonds by 90bp (+2.0%).
Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.