Volatility Warrants Caution in U.S. High Yield
In a period of falling interest rates, yield is dear, and high yield therefore remains an attractive asset class. However, with increased interest rate volatility and uncertainty around economic growth, Portfolio Manager Seth Meyer says a cautious approach and a focus on strong company fundamentals are warranted.
- Current market volatility is the result of renewed trade tensions between China and the U.S. and Federal Reserve Chairman Jerome Powell’s elusiveness on the topic of lowering rates to support economic growth. Both events are occurring at a time when the U.S. high-yield market is at expensive valuations.
- We believe the swift rise in negative-yielding global debt – now around three times what it was less than a year ago – makes high yield an attractive asset class for investors.
- However, we are cautious on the U.S. high-yield market at current prices, as we think bond markets may be too optimistic on the outlook for the U.S. economy. As such, we believe investors should remain focused on seeking companies with strong fundamentals.
Seth Meyer: I think what’s important for investors to remember is that bouts of volatility like what we were just experiencing right now are something that either create opportunity – or as an investor or someone who’s invested in markets in high yield or equities – a time to sit back and reevaluate what’s happening. Recall, Q4 of last year, we had a significant widening and sell-off of risk assets. We had a very similar event happen in … after … post Q1 this year. We’re absorbing something right now.
What actually caused what’s happening right now? If you think about the confluence of events that have actually happened over the past week, the tweets from Trump – that was definitely a situation that caused some issue as far as what was happening with China and U.S. relations in regards to trade and how we’re going to price risk assets in regards to U.S. and global economic growth going forward.
Couple that with the Fed meeting. I thought the Fed did a really good job of addressing the concerns of the market. I thought there was one specific comment that he made that actually is making the markets a little uneasy: When asked whether or not we are entering an easing cycle, Chairman Powell was very hesitant in saying whether or not we’re actually going down the path of an easing cycle. I think the market really wanted to hear that [“We’re] here, we know we need to potentially ease … economic growth is slowing … We don’t know how much, but we’re here just in case we need to.”
I think those two events really caused the markets to really reevaluate the outlook, particularly considering where valuations were at the time. U.S. high-yield spreads had gotten to a level that were pricing in really good economic growth and really low default rates. Those two things were coming into question as we started to see … as the two events that I mentioned before really started influencing asset prices.
When I look at the U.S. high-yield market right now and what’s really happening as far as reevaluation, it’s really been specific to certain sectors. Oil and gas as a great example. We are having a significant repricing in oil and gas bonds right now. Part of it doesn’t even correlate with what’s happening with oil prices. So oil prices are down, economic growth is slowing, but the prices on some of these bonds have revalued so significantly so quickly, it’s either telling us the market won’t be there when they need to refinance … oil prices, we expect them to continue to go lower … or it’s an opportunity to get involved in some of these names that have been really beaten down. As we look at that sector in particular, it’s not one that we’re actually adding to at this current point just because we can’t get comfortable with sort of the outlook of where we think oil prices are going to go.
We focus on three things: They need to be generating free cash flow, they need to be a solid basin, and have a management team that’s focusing on deleveraging the balance sheet. We’re not seeing that in a lot of the companies that you would be … that are beaten down as much as they are right now. So right now, we don’t view it as a great opportunity.
As we look forward in the U.S. high-yield market as a whole, I still think it’s too early to get … to jump in. We are being very cautious in our approach to the market right now just because the economic growth, the downshift of the economic growth, we don’t know how severe it could be. And at current spread levels, we’re not 100% sure we’re being priced for what that could be as far as a downshift on the growth. So as I look forward, I think we remain cautious but opportunistic if we find great ideas that we can actually take advantage of.
I think one other point that’s causing Treasury rates to really be dramatically impacted about what we’re seeing … I think the number of this morning was $14.5 trillion in sovereign debt that is now negative yielding, an all-time record as you would expect. I think the bigger point is it’s three times the amount that we had in October 2018. So it hasn’t even been a year, and we have now tripled the amount of negative-yielding debt in the world. That has an impact. What kind of impact? Think about the U.S. Treasury. The U.S. Treasury is 165 basis points lower than it was in October 2018, today.
As more debt goes negative, U.S. Treasury yields come lower. Makes logical sense. As an investor, yield is dear. You need positive-yielding assets. It’s one of the reasons from a technical perspective the high-yield market remains a good asset class to continue to be invested in. The problem is the fundamentals may be weakening at the time where technical and yield is something that investors really need. So that’s the balancing act of paying attention to investors’ need for yield but weakening fundamentals and how they play out. So [that’s] one of the reasons we’re remaining cautious as we’re looking forward.
Basis Point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
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