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Fixed-Income Insights

Here’s a look at three factors that could result in widely differing returns among high-yield sectors in 2015.

 

In Brief

▪ We believe 2015 may offer greater than normal performance variance within the high-yield bond market.

▪ Three important factors could result in divergent returns across sectors of the high-yield bond market:  
1) Falling oil prices
2) A stronger U.S. dollar
3) Republican control of the U.S. Congress

▪ The key takeaway—The divergent impact on high-yield issuers by the factors listed above could create opportunities for research-driven active managers.

 

In our last column, we examined the topic of divergence—specifically as it relates to how economic and monetary policy prospects for the United States differ from the rest of the developed world. But we believe divergence also will be a key theme in various asset classes—including U.S. high-yield securities.

While we maintain that not all high-yield bonds are created equal, 2015 may offer greater than normal performance variance within the asset class. Such divergence may create greater opportunity for perceptive active managers to distinguish their performance from the returns of benchmark indexes or passively managed strategies. 

The recent decline in prices for high-yield bonds may entice some investors to broadly increase exposure to the asset class via an index. But while current valuations suggest attractive returns are possible for the entire high-yield category, the environment in 2015 seems to presage important return differentials within the asset class.

What could lead returns in key sectors of high yield down different paths in 2015? We’ve identified three important factors: 

1) Falling Oil Prices
The most obvious contributor to potential return differentials is the price of oil, with the benchmark West Texas Intermediate grade of crude down more than 50% since June 2014, according to Bloomberg. Plummeting energy prices and differing accounts of their impact on U.S. shale drillers produced investor flight from the entire high-yield asset class and vanishing interest in high-yield credits associated with the oilfield services and exploration and production (E&P) industry groups. Investment outflows from the asset class pressured lower the prices of most high-yield issues, producing wider than historical average yield spreads for the J.P. Morgan U.S. High-Yield Index by year-end. At the same time, a near absence of interest in bonds of energy companies caused spreads to widen even more significantly within that sector. Regardless of the future movement in oil, though, the foundation is in place for performance differentials across high-yield sectors. 

Within energy, gas distribution and oil refining and marketing are two groups that are likely to outperform oil services and E&P, especially if oil fails to rally above $75 per barrel. Outside the energy sector, investors should expect relatively attractive performance for industries able to benefit from lower-priced oil. Within the consumer goods, retail, leisure, and transportation sectors, for example, the research capabilities associated with professional management could uncover companies from restaurant chains to cruise lines that can expect additional customer traffic and lower costs related to a 50% drop in the price of oil.

In the extreme, if oil continues to fall, its impact on the high-yield market could be twofold. Lower energy prices could create an increase in defaults within vulnerable industries, as well as an uptick in credit upgrades for those groups poised to benefit—perhaps the ultimate example of divergence within an asset class.

2) Strong U.S. Dollar
Beyond oil, another source of potential differences in high-yield performance in 2015 likely will be U.S. dollar strength. Similar to lower oil prices, dollar strength likely will allow the U.S. consumer to boost spending, this time through lower-cost imports. The lower cost of imported goods also may favor specific high-yield issuers who import a significant amount of what they produce in terms of materials, components, and subassemblies. Since June 2014, the U.S. dollar has risen 13–15% versus the euro and the yen, according to Bloomberg, which could favorably affect the earnings of high-yield issuers.

On the other hand, while many companies that issue high-yield debt have U.S.-focused businesses, earnings could be compromised at companies whose exports or overseas operations contribute meaningfully to sales. Profits at such companies could be impaired after overseas revenues are translated back to a stronger dollar. 

Much like the drop in oil prices, U.S. currency strength in 2015 creates opportunities among high-yield issuers for performance differences that have not existed in recent years. Effective research, analysis, and security selection could address the consequences of broad themes such as a strong dollar and lower oil prices, and thereby add meaningfully to high-yield performance in 2015.

3) Congressional Changes
Republican control of both houses of Congress is another emerging factor for 2015 that could lead to opportunity within the high-yield sector. The Obama administration likely will prevent certain items on the GOP’s wish list, such as a repeal of the Affordable Care Act, from becoming reality, but other legislation that creates investment opportunity for certain sectors could succeed. For instance, passage of the Trans-Pacific Partnership (TPP) could benefit a variety of companies by boosting exports. Conversely, additional imports under the same TPP pact could adversely affect other U.S. companies, as currency-advantaged foreign companies gain less restricted access to domestic markets. Again, such legislation creates opportunities for active managers to be able to distinguish among companies likely to be affected differently. 

The prospect for oil and gas pipeline approvals (with or without Keystone XL) and increased funding for highway repair and improvement holds potential for engineering, construction, and related companies that have seen little infrastructure spending to date. Collectively, the results of a shift in emphasis in Congress from ideological positioning to actual legislative accomplishments could produce concrete economic results for specific companies. This, in turn, could present investment opportunities that diverge from average high-yield performance.   

Investment Implications
The anticipated performance divergence within high yield differs from the more broad-based performance characteristics of the asset class during the past several years. Beginning in 2009, for example, high-yield returns benefited from sector-wide compression in the yield spread versus investment-grade corporate debt, which added handsomely to relatively attractive coupon returns. This broad, constructive movement pushed yield spreads well below historical averages and was then followed by the “risk-on, risk-off” investor behavior in 2013 and 2014. This investor uncertainty added volatility to returns, and most recently pushed spreads in the high-yield market to levels that are wider and, therefore, cheaper than their long-term averages. 

The high-yield sector began 2015 at this more attractive valuation level, and although low interest rates among major global economies, combined with anticipated U.S. gross domestic product growth of 2.5–3.0% (based on Lord Abbett projections) should benefit the entire high-yield sector, broad macro issues seem positioned to create greater performance divergence than we have seen since before the economic downturn. The binary impact on high-yield companies of lower oil prices and a stronger U.S. currency, as well as the potentially positive impact of congressional action, seem destined to create diverging opportunities in 2015 that can potentially be captured by research-driven active managers.

 

ABOUT THE AUTHOR

THE EMERGENCE OF DIVERGENCE

What’s the watchword for fixed-income investors in 2015? Divergence. In this series, Zane Brown looks at the prospects for widely varying performance—and investment opportunities—within:

Global Economy & Policy 
High-Yield 
Emerging Markets
• Municipal Bonds

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