Did the 2014 Volatility Create a 2015 Opportunity? The Outlook for High Yield
The tumbling oil market put junk bond prices On a slippery slope in late 2014. Total returns on high-yield bond indexes tracked by Barclays fell into negative territory in mid-December for the first time since 2011, as investor fear about downside risk associated with energy-related junk bonds spilled over into the rest of the high-yield market. While the slide in high-yield valuations may have disappointed some investors, Ivy High Income Portfolio Manager Chad Gunther believes it created some potentially attractive opportunities in the high-yield credit market. Below he shares his views.
Oil slick
The drop in oil prices was one of the big stories through the last half of 2014. West Texas intermediate crude, which was trading above $100 per barrel over the summer, was less than $60 per barrel in December and ended the year at $53.27. While lower prices are good for consumers, the sharp decline was not welcomed by investors holding high-yield bonds of energy producers.
With increasing energy production in the U.S., the industry has taken on a larger role in the high-yield market in recent years. According to Barclays data, oil-related issuers currently account for about 14% of the market, up from about 5% in 2007. By some estimates, energy bonds currently account for as much as 18% of the high- yield market on a dollar basis. The selloff in those bonds was a significant event for the market, but it became more substantial because it occurred in an environment where some investors were already concerned about high-yield valuations.
As we wrote previously (“Summer school: A technical lesson from the high-yield market”) pundits were expressing concern about valuations early in 2014 and in mid-July Federal Reserve Chair Janet Yellen said the central bank was concerned about a “reach for yield” in the market. Those comments not only fueled a bout of summer volatility, but continue lingering in the minds of investors.
Additionally, there have been concerns about market liquidity, with new regulations drafted after the 2008 credit crisis now presenting a potential roadblock for banks that had in the past acted as buyers and been able to cushion market selloffs. So far, our experience has been that liquidity has taken on more of an issue, but not to the scope that some have feared.
Looking ahead
No question, there has been a lot of downward pressure on the market, mainly in our mind from three factors: outflows, oil prices (energy is the largest sector within the high-yield market) and the end of the Federal Reserve’s quantitative easing. However, the events of late 2014 have us excited about the potential opportunities in high yield in 2015.
Our key views:
- We believe the negative sentiment has created more favorable risk/reward opportunities.Generally, gross domestic product (GDP) growth is good for the high-yield sector because a stronger economy potentially boosts borrower income. As a result, yields can move lower with expected GDP growth. However, in this case, yields have moved the other way. For example, yield-to-worst on the J.P. Morgan U.S. High-Yield Index was 7.58% on Dec. 18, 2014 – compared with below 5.5% in early July – despite little fundamental change in growth projections.
- We do not see a wave of defaults on the immediate horizon.Although some in the financial press are predicting a wave of high-yield borrower defaults, we do not believe the fundamentals support that view. If oil prices remain exceptionally low for a lengthy period of time we believe energy defaults would increase in late 2016 into 2017, but we do not currently expect this to occur.
- We may increase our underweight energy exposure to capture favorable opportunities.When oil prices were sinking to their lowest levels, we were underweight energy, which was to our benefit. As of 11/30/2014, energy accounted for approximately 5.4% of the Fund compared with 15.5% of our benchmark BofAML U.S. Master II High Yield Index. We expect our exposure to increase as we take advantage of the lower valuations in early 2015.
- Individual credit research remains paramount to our overall Fund strategy and our energy positions.As in any market environment, our focus remains on researching the potential value and risk/reward relationships of each credit where we invest. In energy, we are focusing on names that we believe can at least break even on an extended period of oil trading at $50 a barrel. We think many energy names can continue to perform in that type of environment.
Past performance is no guarantee of future results. The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Jan. 21, 2015, and are subject to change due to market conditions or other factors. Holdings and weightings are subject to change.
Investment return and principal value will fluctuate, and it is possible to lose money by investing.
The J.P. Morgan U.S. High-Yield Index measures the investible universe of U.S. dollar domestic high yield corporate debt, and the BofAML U.S. Master II High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market.
Risk factors. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Loans (including loan assignments, loan participations and other loan instruments) carry other risks, including the risk of insolvency of the lending bank or other intermediary. Loans may be unsecured or not fully collateralized may be subject to restrictions on resale and sometimes trade infrequently on the secondary market. These and other risks are more fully described in the Fund’s prospectus.
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