Investments

A Return to “Normal” for High Yield?

yield-sign-smallAlmost two full months into 2015, the high yield market has stabilized in line with a stabilization of oil prices. While we haven’t seen a full recovery of last year’s oil shock, high yield has returned to a period of relatively low volatility as well as more “normal” market conditions – the most favorable environment for high yield investors. High yield still has much lost ground to recover, but recent action appears encouraging.

 

Like most bond segments, high yield bond prices respond to incoming and outgoing capital flows. The chart below from Lord Abbett shows positive movement in that regard.

 

Each bar represents one week of demand for U.S. high yield securities. You can see inside the red circle that capital was fleeing the segment at a rapid pace in December. The pendulum swings the other way inside the green circle as money flowed in during January and early February. We will continue to monitor demand for high yield as well as developments with energy companies as they adapt to lower oil prices. Both factors will continue to affect high yield this year and beyond.

 

HY-flows

 

With focus off the energy sector’s impact on the high yield market, at least for today, we turn our attention to the Fed. The entire fixed-income market wants to know when the Federal Reserve will begin raising interest rates. In congressional testimony this week, Fed Chair Janet Yellen said, in effect, “You’ll know when we do.” Yellen and other Fed officials say their policy is “data dependent.” They want to see inflation move back toward their 2% target, but not go too far above that level.

 

The futures market indicates most traders expect the Fed not to raise rates until late this year. Whenever it happens, what will be the impact on high yield vis-à-vis other bond sectors?

 

Historically, high yield bonds have performed well in periods of rising rates. In four of the last five intervals of Fed rate hikes since 1986, the Bank of America/Merrill Lynch High Yield Index outperformed the interest rate sensitive U.S. Barclays Aggregate Bond Index, a broad benchmark of U.S. fixed income securities. In three of those five periods, the High Yield Index outperformed the two-year Treasury note as well.

 

If that pattern holds true in the next cycle, high yield could outperform other bond segments by a significant margin. Much depends on continued economic growth with mild inflation. That combination has historically been positive for high yield. We talk sometimes about this being a “plow horse” economy, with steady but unspectacular growth. This kind of economy helps businesses strengthen their balance sheets and creates generally better credit conditions. It should help high yield deliver positive results moving forward.

 

While important questions remain about the energy sector’s credit quality and possible defaults, for now high yield market conditions are in a more “normal” state than a few months ago. The environment today looks stable for high yield, but oil prices remain a risk factor to monitor.

 

We have turned our attention to the timing of possible interest rate increases. History shows high yield typically performed well in rising rate environments, especially with the economic factors that favor interest rate normalization today. We will keep monitoring the market closely, and as always, our tactical strategy will seek to take advantage of a positive market while staying on guard to exit when market risks return, whatever their cause.

 

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