The most important indicators for high-yield bond prices are the sector’s own price trends. At present, technical indicators strongly suggest a continuation of the high-yield bond strength that began in mid-February as the flight-to-quality urge faded. In addition to technical price trends, several backdrop indicators also suggest a favorable outlook for high-yield bonds.
· GDP. The most important backdrop indicator for high-yield bonds is whether GDP is contracting or expanding. During recessions, companies default of interest payment and high-yield bonds decline as a group. Last Friday’s jobs report clarified the outlook on recession—showing that recession is a very remote prospect.
Here then lies a classic opportunity for high-yield tactical investing: a recession is priced into the market, yet expansion of GDP is more likely. Yield spreads—the difference between interest rates on riskier bonds and the rates on risk-free bonds—are at levels that historically coincide with significant recession risk (and elevated defaults). We may not see even a modestly higher level of defaults later this year, considering likely GDP expansion of 2.5% this year and a strong employment backdrop.
Employment metrics, including both the participation rate and unemployment rate, strongly suggest economic strength. Furthermore, small business sentiment is favorable; with 42% of employed people working at small businesses, this gauge of optimism functions as another employment metric. Gross production of goods and services—that is, GDP—is a direct reflection of employment levels.
Also, the savings rate has moved higher. Further improved employment and consumer confidence may lead to higher spending levels. Wage growth has been slow, but improvements in core inflation suggest that overall demand is strong. All these factors point to GDP expanding, not contracting.
· Oil. Oil prices have been correlated to both stocks and high-yield bonds. Now oil is up sharply year to date, with an upward acceleration in oil prices more likely than not given both economic expansion coming clearer and constrained supply by oil-producing nations.
Low oil prices hurt the high-yield market because of the risk of default by energy companies. Last year, high yields had modest gains as oil stabilized. OPEC and other suppliers have finally come together as their cash flows are lower to an extent that even Saudi Arabia issued bonds for the first time in many years to fund needs that were normally covered by oil sales. A lift in oil prices could be perceived by high-yield investors as a remarkable buying opportunity, which could in turn bring trading volume up over the next several weeks or months and drive high-yield bond prices higher.
Consumers have used the break at the pump to save money but signs are that they are now spending (finally) some of this savings. For example, purchases of larger cars are up and auto sales have been higher than expected by many.
The correlation of oil, stocks, and high-yield is strong—but so is the relationship of higher oil to inflation. Inflation equals a demand tendency. In short, the thesis of higher GDP is reinforced by oil moving higher.
· The Dollar. We think the upward momentum of the dollar has abated. Previously, the high dollar was causing severe negative impacts on profits for U.S. large-cap companies with international operations. This change in the dollar trend may help stabilize business sentiment. We believe the dollar’s relationship to business sentiment is a key factor for members of the Federal Reserve, given business sentiment’s connection to much-needed capital expenditure to improve productivity, which has been lagging, and in turn to stabilize long-term employment and inflation trends.
All these background indicators are secondary in comparison to the actual price trends at work in the market. In the context of those price trends showing strength, we see these supporting factors as significant enough to support the view that high-yield bonds are likely to see further prices increases despite turbulence.
Currently BTS is bullish on high yield as a sector given about a 9% average yield to maturity and spreads around 700-800 bp. But we continue to advocate a risk managed approach to the sector. Defensive allocation out of the high yield sector may become necessary despite the fact that a higher default rate is priced in along with the risk of lower oil prices and other factors.
Disclosures:
This commentary has been prepared for informational purposes only and should not be construed as an offer to sell or the solicitation to buy securities or adopt any investment strategy, nor shall this commentary constitute the rendering of personalized investment advice for compensation by BTS Asset Management. This commentary contains views and opinions which may not come to pass. To the extent this material constitutes an opinion or assumption recipients should not construe it as a substitute for the exercise of independent judgment. This material has been prepared from information believed to be reliable, but BTS Asset Management, Inc. makes no representations as to its accuracy or reliability. The views and opinions expressed herein are subject to change without notice.
It should not be assumed that investment decisions made in the future will be profitable or guard against losses, as no particular strategy can guarantee future results or entirely protect against loss of principal. Investing in fixed income securities involves risks, including interest rate risk, credit risk, and reinvestment rate risk. Investing in lower quality bonds, known as high yield bonds, involves additional risks, including default risk.
