The Election Impact on the High Yield Market: Rates and Regulation, Part 1
By Heather Rupp, CFA, Director of Communications and Research Analyst for Peritus Asset Management, Sub-Advisor of the AdvisorShares Peritus High Yield ETF (NYSE Arca: HYLD)
Now that Trump has surprised virtually everyone with his Presidential victory, what does that mean for the high yield market? For us, it looks like the two most relevant impacts are rates and regulations.
First, let’s look at rates. The 10-year has gone from 1.83% on Monday, November 7th, right before the election to cross above 2.2% one week later. Yes, this is a sizable move and has been primarily attributed to a couple of underlying factors, both of which we view as potential positives. First is the expectation that the Trump/Republican initiatives, including infrastructure spending and other fiscal stimulus, will drive economic growth. Second is the idea that with a Republican controlled House and Senate, tax cuts are very likely to get passed, and those tax cuts in turn could cause demand-pull inflation. We know that consumer spending is nearly 70% of GDP, so whether it is tax cuts putting more money into the hand of the consumer or the infrastructure spending improving the job situation, we would see both as positives from an economic growth perspective.
Prices of high yield bonds have historically been much more linked to credit quality than to interest rates. The biggest cause of spread widening (price declines) over the years has been spikes (or anticipated spikes) in default rates.
On the flip side, historically, interest rates are usually increasing during a strengthening economy and a strong economy is generally favorable for corporate credit and equities alike. We believe investors should focus on default/credit risk when investing in the high yield sector, paying attention to the company’s fundamentals and credit prospects. When the economy is expanding, profitability, financial strength, and credit metrics generally improve. After years of muted economic growth, we would view a stronger economy as undoubtedly a positive from a credit perspective and we would expect that could indicate lower default rates, meaning probable improved prospects for high yield issuers and the broader market.
But this stronger job market and economic growth and potential inflationary pressures could mean that the Fed is more aggressive in increasing rates than we would have expected a month ago, and we see the various securities on the Treasury yield curve are reflecting this possibility. As we have noted again and again (see our piece “Strategies for Investing in a Rising Rate Environment” and “High Yield in a Rising Rate Environment”), historically the high yield market has performed well during periods of rising rates, helped by the improving economy that has traditionally corresponded with increased rates, as well as the higher starting yields and a lower duration we generally see in the high yield market versus other fixed income sectors, both of which help reduce duration (a measure of interest rate risk).
However, keep in mind the high yield market is not homogeneous. As we have seen a swift rebound in high yield bond prices so far this year, we have seen spreads compressed to very low yield levels on a number of high yield issuers. In looking at the Bank of America High Yield Index, nearly 40% of the individual tranches trade at a yield to worst of 5% or less 1 . So if we were to see a 1% increase in rates, that would have a much more significant impact on these securities yielding 3 or 4% within the high yield market, and investment grade and municipals that are yielding even less, versus the securities yielding 7, 8, 9% or even more, also available within the high yield space. This is where an actively managed high yield portfolio can be of value, whereby managers can avoid these lower yielding securities that may have more interest rate sensitivity and focus on where there is value to be had.
While we have so far seen a notable step up in Treasury bond yields and do expect that if some of this proposed economic stimulus pans out, and some inflation along with it, we may see rates rise further. But we still believe there will be a solid global demand for the US Treasury bonds given our rates relative to the rest of the world and the global demographics, which we believe will constrain our rates from a huge move upward. But in the face of some potential move higher in higher rates, investors should evaluate their fixed income options, paying attention to duration. As an active manager, we believe we have the flexibility to take advantage of opportunities that may open up on the credit side and position ourselves in securities where we feel the yield is adequately compensating us. By the nature of our investment strategy, we tend to focus on higher yielding securities and that, along with the ability to include floating rate loans, tends to allow us to have a lower duration.
While interest rates are a valid concern for investors as this juncture, it is worth repeating, high yield historically has been more tied to credit quality than interest rates, so we would certainly see a sustained economic recovery and a better positioned consumer to our benefit. With renewed focus on the potential for rates to rise, the high yield market has backed up a bit over the past week and spreads have widened, and with this, we have started to see some of the high yield exchange traded funds begin to trade at discounts to their NAV. Given our expectations for the long-term benefits that may come from this election, we don’t believe these notable discounts are warranted and believe this could be an opportunity to put money to work in the high yield market.
1
Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Default Monitor,” J.P. Morgan North American Credit Research, November 1, 2016, p. 7, http://hvst.co/2aMzpln
2
The Bank of America Merrill Lynch High Yield Index monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. Index data sourced from Bloomberg, as of 11/7/16.