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Market View

Recent declines in high-yield bonds seem to have been driven more by company- and sector-specific factors than by macro issues affecting the credit fundamentals of the overall market.

After a period of strong performance, with the BofA Merrill Lynch U.S. High Yield Index (“High Yield Index”) rallying 17.5% in 2016 and another 7.5% year to date through the end of October 2017, the U.S. high-yield market experienced a bout of volatility in mid-November. 

After reaching a recent low point on October 24, high-yield credit spreads widened by 60 basis points over the following three weeks. Selling pressures accelerated in the week ended November 15, as media reports highlighted that the largest high-yield exchange traded funds (ETFs) declined by more than 1% during that week. As is often the case in periods of price declines, high-yield mutual funds experienced outflows: for the week ended November 15, Lipper reported more than $4.4 billion in outflows from high-yield mutual funds (including $1.8 billion in outflows from ETFs), the fourth largest on record. Some have suggested that this was the signal of the end of the cycle for high-yield bonds and, perhaps, a signal of impending trouble for the broader markets and the U.S. economy.

A Closer Look
A more thorough look under the hood, however, may suggest a different picture. While recently the high-yield asset class has been under pressure, there has been a very wide dispersion of returns by sector within the High Yield Index. For example, the broad Index had suffered a decline of approximately 1.3% for the month-to-date period through November 15. However, the telecommunications sector was the major driver, with a loss of more than 4.4%; the healthcare, retail, and consumer products sectors were all down more than 2%. Meanwhile, other sectors, such as transportation and energy, and basic industry groups, such as metals and mining, were down less than 1%.

 

Chart 1. Recently, There Has Been a Large Gap in Returns Between High Yield's Top and Bottom Sectors
Month-to-date performance, by sector, as of November 21, 2017

Source: BofA Merrill Lynch U.S. High Yield Index. Past performance is not a reliable indicator or guarantee of future results. It is important to note that the high-yield market may not perform in a similar manner under similar conditions in the future. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

The decline in high yield seems to have been driven more by idiosyncratic stories affecting specific issuers and sectors, as opposed to broad macro issues impacting the credit fundamentals of the overall high-yield market. Within telecom, for example, failed merger talks and a series of weak earnings reports led to significant price declines in large benchmark names. Elsewhere, issuers in the healthcare, media, and retail sectors each face their own unique secular headwinds. Those managers who were able to underweight or avoid these troubled areas were well positioned to outperform.

Despite this recent volatility, we believe that the backdrop fostering a positive environment for high-yield credit remains in place.

  • The U.S. economy appears to be on a positive course, with recent gross domestic product readings indicating a 2%-plus pace of growth. Likewise, growth prospects from Europe and Asia are positive.
  • Inflationary pressures remain in check, allowing the U.S. Federal Reserve to go forward with policy normalization at a very slow and gradual pace.
  • High-yield default rates remain low: the latest 12-month default rate for high yield declined to 1.18% in October, compared with 3.57% at the start of the year, according to JP Morgan.
  • Corporate liquidity remains sound; Moody’s recently reported that its Liquidity Stress Index had dropped to a new low in November.

Investors seem to have recognized some of these factors, as the high-yield market bounced back with positive returns over the week ended November 21, 2017, with some of the more beaten-down sectors leading the way. Still, there has been a large gap in returns between the top and bottom sectors, for the month- and year-to-date periods, as summarized in Chart 1.

This experience is not unusual. As we have pointed out before, there typically is a very wide gap in performance for the best and worst sector in any given year (see Chart 2). More important, the large dispersion of returns within the U.S. high-yield market underscores the potential benefit of an active approach to high-yield investing.

 

Chart 2. A Gap in Performance among High-Yield Sectors Is Not Unusual in Any Given Year, and 2017 is No Exception
Year-to-date performance, as of November 21, 2017

Source: BofA Merrill Lynch U.S. High Yield Index. Past performance is not a reliable indicator or guarantee of future results. It is important to note that the high-yield market may not perform in a similar manner under similar conditions in the future. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

What might investors take away from this recent market experience?

  • Headlines often do not give the true picture of underlying market dynamics. Sometimes you have to dig below the surface to understand what is driving the market.
  • Given the wide range of returns within high yield, there’s a strong case to be made for active management. Rather than matching the exposure of the largest issuers of high-yield debt, an active manager can undertake rigorous, fundamental credit research on individual issuers and choose to overweight the most compelling opportunities, while avoiding those credits that pose the largest risk of default or trade at unattractive valuations.
  • While bottom-up research is required to avoid credit issues, we believe a top-down view is vital to successfully navigate the high-yield market. An investor solely focused on bottom-up credit selection may miss important broad market and sector trends. A seasoned investment team’s macro insights may lend themselves to favoring those industries that are best-positioned for the economic environment, while adjusting overall risk exposure across the credit-rating spectrum.

 

Table 1: A Top-Down View is Key to Navigating the High-Yield Market
Year-end performance, by sector; Year-to-date 2017 as of November 21

*Source: BofA Merrill Lynch U.S. High Yield Index. Past performance is not a reliable indicator or guarantee of future results. It is important to note that the high-yield market may not perform in a similar manner under similar conditions in the future. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

A passive strategy would have had no choice but to fully allocate to the energy sector in 2015, the largest sector of the High Yield Index, and the worst performing group that year (see Table 1). More recently, a passive approach would have full exposure to the healthcare and telecom sectors, for example, despite the secular headwinds and idiosyncratic risks that many large issuers face. Even if underlying credit fundamentals, valuations, and the economic environment were to suggest that these areas of the market were most at risk, a passive approach would be fully invested there.

Our Outlook
The current credit cycle has lasted longer than many would have expected. However, the cycle does not necessarily have to come to an end due to old age, or because spreads are below average. In a scenario whereby the United States avoids an economic downturn, the economy continues to grow, and defaults remain low, high yield offers the potential for positive performance. The long-term risk/reward profile of the asset class suggests that high yield deserves consideration as a strategic allocation for many investors’ portfolios, but an active approach may be better suited to navigate the inevitable bouts of volatility. 

 

MARKET VIEW PDFs


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