Global high yield credit: Keep calm and carry on

Jun 4th, 2018 | By | Category: Fixed Income

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By Morgane Delledonne, ETF investment strategist, BMO Global Asset Management.

Morgane Delledonne, ETF investment strategist, BMO Global Asset Management.

Morgane Delledonne, ETF investment strategist, BMO Global Asset Management.

Synchronised economic growth coupled with a gradual normalisation of monetary policy in developed economies should continue to be supportive for high yield credit in the medium-term. Higher oil prices and rising interest rates have led investors to favour shorter-duration bonds with cyclical tilt, leading to the outperformance of high yield over investment grade bonds. Besides, over the long-term, high yield corporate bonds tend to perform similarly to equities with lower volatility.

Global activity remains robust with global PMI series recording strong readings despite a slowdown in the first quarter mainly reflecting temporary factors, notably weather-related circumstances. While headline inflation could push higher, boosted by rising commodity prices and a strong global demand, cyclical core inflation pressures are benign and partly offset by long-term structural deflation in most developed countries.

Source: BMO GAM.

The main risk to the current stable outlook is an unexpected rise of headline inflation, from a sharp increase in oil prices, which could push the Federal Reserve and other central banks to increase interest rates at a faster pace than currently priced in the market. Another unforeseeable risk to global markets is geopolitics. The threats of a trade war between US and China, a possible confrontation between the US and North Korea, and mounting tensions between OPEC countries could cloud the positive global economic backdrop and lead to a flight to safety.

Meanwhile, global high yield issuers’ fundamentals look robust, profit margins are rising in aggregate level while the median leverage ratio is trending lower. The extended period of low interest rates have allowed most high yield issuers to refinance their debt at a lower cost. The gradual tightening of financial conditions in the US and the all-time low borrowing costs in Europe should continue to support high yield markets in the near term.

What’s more, the global high yield default rate is expected to decline to 1.8% by the end of this year compared to a long-term average of 4.2%, the lowest since 2008, according the Moody’s. In particular, European high yield issuers’ default rate is expected to fall to 1.1% in December, the lowest rate in a decade and below the projected default rate of 2.4% for US issuers.

Source: BMO GAM.

Source: BMO GAM.

Since the beginning of the year, global investment grade credit lost 3.2%, while high yield credit lost 1%, suggesting that the negative returns were mostly due to the rise of interest rates rather than a decline in credit fundamentals. The high yield segment has generally been resilient in the previous Fed’s tightening cycles, because it is less sensitive to interest rates than investment grade credit. Since the Federal Reserve has started to increase the fed funds rate in December 2015, global high yield credit has outperformed investment grade credit.

Source: BMO GAM.

Source: BMO GAM.

The energy sector has been the best performer in total return terms in the global high yield bond market this year, returning 1.7% year-to-date, after Brent crude oil price approached $80 per barrel. The rising tensions between OPEC countries could lead to adjustments in the agreement on curbing production until the end of 2018. While Saudi Arabia has agreed to mitigate the likely drop of Iranian crude’s production resulting from the US sanctions, oil prices are likely to continue trending higher.

The US Treasury yield curve has flattened substantially and bond spreads are tight by historical standards. In particular, global high yield spreads are in the 17th percentile (i.e. spreads have only been tighter 17% of the time since 2000), leaving capital appreciation limited. However, markets are already pricing in three to four rate hike from the Federal Reserve this year, reducing the risk of a sharp yield curve adjustment in the medium-term, unless inflation unexpectedly rises significantly above 2%. Furthermore, the total return in high yield bond markets is mostly sourced from coupons, which are considerably higher compared to investment grade credit.

Source: BMO GAM.

Source: BMO GAM.

While global high yield ETFs have recorded net outflows of $4.1 billion year-to-date, they have seen net inflows of $2.5bn since March, according to Bloomberg data. Overall, the positive carry (i.e. the coupon rate of the bond index minus the funding rate) should offset the negative price impact from slowly rising interest rates, limiting the risk of a prolonged period of negative returns in the medium-term.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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