Since the high yield bond market lows in mid-November, prices recovered and have now moved somewhat above the late-October highs. This process has been slow—and we remained suspect that an intermediate-term trend had not been established. Now, however, we believe probabilities have increased that prices will continue to move higher, reflecting a systemically strong trend.
Intermediate-term price strength often continues while credit spreads tighten. From the current level, a 100-basis-point tightening of spreads would move the risk premium to historical lows and reflect expectation for a yet stronger economy and yet lower defaults.
Treasury Yield Considerations
But of course risks remain. The 10-year Treasury yield broke the resistance area of 2.63% that we have been monitoring, reaching 2.66%. A further increase in yield would suggest that fixed income in general will struggle.
A breakout of yields to new highs could spur additional bond selling—but such a breakout does not appear imminent. Despite indications that central banks may be slowing their purchases of U.S. Treasuries bonds- a high bid to cover ratio after at a recent auction of the 10-year note- suggests that a strong ‘bid’ remains and current yields are attractive.
The recent move up in Treasury yields may be a reason that high yields have not shown their typical correlation with stocks in recent months. At this point in the business and credit cycle, credit spreads are relatively tight, potentially limiting upside in high yields in the short run. That said, it is possible that high yields may “catch up” with the stock market, especially if Treasury yields fall back.
Additionally, there is the potential for spreads to tighten to all-time lows, which could lead to price appreciation in addition to income from the approximately 5.25% interest yield.
Inflation Considerations
Inflation reports at higher readings, together with the gains in wages and strong employment figures, may be a catalyst that pressures yields beyond the 2.66% level and thus a new 52-week high. Some components of core consumer prices (CPI Core) have been accelerating, and we think there could be upside surprises to inflation expectations as the Federal Reserve tightens policy rates.
In order to fully discount the risk factor of higher inflation, stocks and high yield bonds will likely need further confirmation from data. A sustained tightening of monetary conditions brought on by higher than expected inflation is a major risk that could unfold in the near term and affect the current trend in risk assets.
Assuming low inflation and lack of confirmation of the reflation and high growth scenario, we then have a flat yield curve to consider as a catalyst for volatility. The last several recessions took place 6-9 months after a flat yield curve developed, so markets may start to discount a slowdown in later 2018.
Tax Policy Factors
The new tax law will have both positive and negative effects on the corporate high yield sector.
First, on the positive side, the corporate tax reduction would increase cash flow to companies and reduce the default risk on interest payments. Together with acceleration in GDP, strong corporate earnings, and global growth, this is likely to lower the default rate.
Second, on the negative side, the loss of deductibility of interest payments coupled with limits on carry-forward of losses would decrease the potential cash flow of corporations. This can affect corporate high yield issuers who have weaker cash flow. In aggregate, the new tax law does not appear likely to impede spreads from narrowing further.
Conclusion
We don’t think economic recession is likely for 2018, but we do see potential that monetary policy normalization will usher in a recession in the second half of 2019. In addition to rate hikes, the unwinding of the Fed’s Quantitative Easing holdings may also have a negative psychological effect, particularly in the context of richly valued prices across most asset classes.
We focus on identifying intermediate-term trends. We are willing to miss short-term gains to avoid intermediate-term losses. Conversely, we are willing to take limited short-term losses to maintain the potential for intermediate-term gains. We take this approach because we believe risk-adjusted returns are more attractive to most investors if they can be achieved with fewer drawdowns associated with recessions and stock market corrections.
Consistent with our models and investment practice, we remained on the sidelines as high yield bond prices ticked up modestly from their mid-November lows. We were willing to forgo some potential gains in the context of a trend that had not become established. From here, while risks remain, we anticipate further price-level gains in the high yield market
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