High Yield Bond Outlook: A Time for Unconstrained Management
Using our unconstrained approach, BTS indicators signaled a move back into High Yield bonds near the end of September. BTS Asset Management views the High Yield bond sector as exhibiting solid fundamentals. Based on historical comparisons, High Yields have strong cash flow coverage for interest payments, due to conservative use of leverage. Post 2008, companies hired less people and have kept other fixed costs down. This, and refinancing at low interest rates, has increased the all-important cash coverage ratios at the majority of companies issuing High Yield - creating a solid foundation for the sector.
Typically a major concern for High Yield bonds and their relative underperformance during recessions is current and projected default rates. Defaults on interest are projected to be on the low side based on historical comparisons. BTS believes this positive outlook for the months ahead is likely to translate into steady High Yield bond market returns from a combination of income and capital gains. The average yield has adjusted upward relative to treasuries, and with government bonds stabilizing, we have a possibility for capital gains, if the economy grows slowly at a non-inflationary rate.
BTS Indicators will continue to focus on preservation of investor capital. Rising interest rates present a major concern. High Yield bonds and stocks historically tend to move in tandem given the relatively high correlation to one another. But, the unique economic setting of ‘zero’ rate policies and the quantitative easing strategy of buying U.S. Treasuries and mortgage backed bonds to maintain low interest rates present a situation that we have not seen before.
Lower rates have been maintained to stimulate housing, business and consumer spending, in an effort to create demand, growth, employment and inflation. However, the economy is at an output gap of about 6% which suggests we may need 3-4% GDP for the next 3-4 years before approaching full capacity, higher wages, greater aggregate demand, and inflation pressures.
The so called Phillips Curve, which plots inflation and unemployment, suggests that inflation levels need to move from 1-1.5% to 2-2.5% or more, before unemployment breaks well below 6% and the participation rate increases.
The Federal Reserve has room to stimulate, and fiscal policy will become less a drag on growth in
2014. But the positives in motion may irk the bond market and ‘spike’ rates higher. We have had a fiscal drag from sequestration, yet the economy has been resilient. The Federal Reserve thinks that we are no longer in need of bond buying strategies, but must maintain the ‘zero’ rate policy and be ready for any reversal.
The consequences of this policy may create rising rates and/or volatility. Rates are likely to move higher as the bond market anticipates that the ‘policy rate’ will move up before the 2015 timetable given by Federal Reserve Chairman Bernanke. In fact, bonds may decline and yields spike due to a discounting of higher growth.
In conclusion, High Yield as a sector is in solid fundamental condition based on historical comparisons. This should help lower volatility. However, High Yield bonds have been affected by rising rates, and stocks may get pulled into a correction if the bond market ‘spikes’ as it did during the most recent summer amid fears that the cost of interest would stifle a potential recovery. This is viewed as an important risk factor for High Yield bonds going forward. A spike in the 10-yr to 4.5% during the next 12-18 months is possible but could set-up a lucrative trading opportunity - especially if the economy temporarily slows due to higher borrowing costs.
In short, there is risk and BTS Indicators may move assets to the defensive. But we think the next 12 months may have solid gains if growth returns in 2014 after the fiscal drag abates and economic spending lifts employment and demand. Against this interesting backdrop, trading opportunities to add value are likely to take place – a tactical strategy could offer value-added to clients.© BTS Asset Management
