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Fixed-Income Insights

Here, we gauge how possible developments regarding the U.S. economic outlook, oil prices, and tax policy could influence high-yield securities.

The recent price appreciation in U.S. high-yield securities has meant that yield spreads above U.S. Treasuries for the asset class have moved below long-term averages. While narrower spreads may be consistent with low, absolute yields—and may properly reflect lower-than-average default rates—some investors may have questions about what could lie ahead for high-yield portfolios. Specifically, the ones we have spoken with have mentioned events related to the economic cycle, oil prices, and tax and fiscal policy proposals.

In response, we have identified five potential developments to watch in these areas, their possible effect on high-yield securities, and the probability of each. We believe our analysis of these factors reinforces the resiliency of high yield as an asset class.

Key Event: U.S. Recession or Economic Slowdown
Possible impact: Economically sensitive companies within the U.S. high-yield sector will see revenues fall and profitability suffer. High-yield prices are not likely to perform well in the risk-off environment that should prevail during a recession.

Probability: A U.S. recession seems unlikely in the current environment of persistent job growth, gradual wage increases, and modest inflation. Economic downturns normally trace a pattern of (1) robust expansion accompanied by (2) excessive borrowing as companies expand capacity, followed by (3) aggressive monetary tightening to slow growth and wring out high inflation. Higher rates and elevated debt levels, in turn, can bring about low or negative growth in the broader economy. None of these three preconditions are currently in place.

Key Event: Oil Prices Plummet
Possible impact: The drop in oil from more than $100 per barrel in August 2015 to below $28 by January 2016 caused significant distress among high-yield energy companies and led to substantial defaults. A drop today from more than $50 back toward $28 would again cause difficulties; but with many weaker energy firms having already defaulted, and the remaining companies in stronger financial condition, the impact is likely to be milder and should produce far fewer defaults. On the other hand, prices sustainably above $55 would bolster profitability of U.S. shale oil producers noticeably, leading to improvement in some high-yield energy securities prices and eventually to credit upgrades.

Probability: With OPEC members aligned against oversupply (for the moment) combined with the elimination of weaker U.S. companies that might have sold oil below cost to delay bankruptcy, there seems little supply pressure to force crude below $45 per barrel, much less to below $30. According to a Wall Street Journal report, some of OPEC’s key members, including Saudi Arabia, Iraq, and Kuwait, are now targeting $60 oil, a level that would be highly profitable for many U.S. shale producers.

Key Event: Implementation of U.S. Tax Reform
Possible impact: With many U.S. high-yield companies paying close to maximum corporate rates of 35%, a proposed reduction in the rate to 20% would enhance profitability and improve balance sheets for many issuers. Some companies might use improved cash flow to reduce debt, further strengthening their credit profiles.

Probability: Tax reform is a key objective of the Trump administration and the Republican Party. Passage of related legislation looks likely for the fourth quarter of 2017, in our view, but difficulties in reconciling different versions of the legislation from the U.S. House and Senate, along with problems with lawmaker disagreements over a so-called border-adjustment tax, could cause meaningful tax reform to be replaced with a far milder bill offering tax cuts over 10 years. Cuts would be welcome, but not as attractive as a more permanent tax reform solution.

Key Event: U.S. Infrastructure Spending Initiatives
Possible impact: Specific U.S. high-yield companies could be direct beneficiaries of a $1.0 trillion spending program over 10 years, including engineering and construction firms, cyber-security companies, materials providers, and heavy equipment makers. To the extent overall U.S. gross domestic product is improved through additional job creation and higher wages, many other U.S.-centric companies could benefit.

Probability: Tax reform and another possible pass at revamping the healthcare system appear to be higher priorities for U.S. legislators than infrastructure spending at the moment. Early 2018 seems more likely than 2017 for passage of an infrastructure spending bill.

Key Event: Elimination of Corporate Interest Deductibility
Possible impact: High-yield companies that are heavily dependent on debt could be disfavored by this potential aspect of tax reform. Such a feature would prompt companies to reduce debt. This provision also could reduce issuance of high-yield debt to finance acquisitions and buyouts.

Probability: Elimination of the deductibility of corporate interest costs is part of a broader discussion on tax reform and could take many shapes. It may be introduced gradually over several years, companies may be allowed to deduct at least a portion of interest payments, or current debt may be “grandfathered.” The combinations of different tax treatments, including the border-adjustment tax and expensing of capital investments, suggest there is considerable uncertainty with regard to many aspects of tax policy.

Summing Up
As an asset class, U.S. high yield seems equipped to weather many of the economic and political concerns facing investors over the coming year or so. In addition to the events discussed above, previous Lord Abbett commentaries have pointed out how high-yield securities have historically performed relatively well during periods of Fed rate hikes or during periods when longer-term rates were rising. In approaching high yield, investors should carefully consider how this lower credit-quality asset class may best fit with their investment objectives and risk tolerances. In this regard, the deep credit research and valuation expertise of professional managers may be an ideal choice.

 

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