When we last updated you on our High Yield program in August, financial markets were still reeling from weeks of China-related volatility and a general dis-ease with the global economic outlook. Now we see markets recovering despite a still-weak backdrop. As a result, we re-entered the High Yield bond sector and wanted to give you our latest thoughts.
Energy has been driving High Yield action this year, and slower growth in China is driving energy. The country’s massive demand for fuel and raw materials drove commodity prices sharply higher in recent years and enticed companies around the world to invest in those sectors. Many financed expansion with High Yield bonds.
The commodity price curve started to break in mid-2014. Crude oil peaked just over $100 then began a steady slide downwards. Other commodity prices followed and default fears started rising for High Yield bond issuers. Those fears turned out to be overdone for the most part. Actual defaults were rare and some companies even raised new debt and equity capital as oil prices stabilized in early 2015.
The respite didn’t last long. As summer began, Chinese stocks began sliding, oil prices retreated again and fear once again swept through the markets. An additional mystery also developed. Would the Federal Reserve finally raise U.S. short term interest rates? Inconclusive economic data and a steady stream of conflicting comments from Fed officials had everyone on edge.
Fed policy affects more than the U.S. economy. Emerging market nations have large amounts of dollar-denominated debt that will be more expensive to repay if the the dollar gains value because the Fed raised interest rates.
As always, our primary task is to assess risk levels and judge whether potential gains outweigh the risk of re-entering the sector. When we talk about High Yield bonds, the “high” part is always relative. It might be more accurate to call them “Higher Yield” bonds. Normally, their interest rate is higher than Treasury or investment-grade corporate bonds. The “spread” between High Yield and Treasury bonds is an important indicator.
Interest rates always reflect repayment risk. If you have a car loan or home mortgage, the lender judged your financial situation and assessed the chance you would miss your payments. The higher the risk, the higher your interest rate.
The same applies to businesses. Stable, established companies operting in a favorable economy can borrow at very low rates. Lenders/bondholders accept lower returns because they feel very confident of recovering their principle.
The U.S. government pays the lowest interest rates because it is the world’s ultimate safe haven. This year the Treasury issued short-term paper at 0% yield. People still bought it, too. To them, safety was more important than yield.
Bond investing is all about keeping risk and reward in the right balance. We moved from High Yield bonds to cash several months ago because that balance had changed. Weak oil prices and slow economic growth raised doubts that companies could stay current on their debt payments.
Now the pendulum is swinging the other way. Rates have moved up enough to again outweigh the risk in High Yield bonds. As often happens in stocks, excessively negative sentiment pushed bond prices below their reasonable valuations.
Currently, High Yield spreads above Treasury rates are higher than historically normal while default rates are well below average. In theory, this is an ideal combination for High Yield investors.
Risk hasn’t disappeared. Federal Reserve policy is still uncertain and third-quarter corporate profits are unimpressive so far. We remain vigilant, but on balance we now believe potential gains outweigh the known risk factors.
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