With global high-yield spreads still quite tight as of this writing, we continue to suggest that investors pursue a slightly defensive risk posture and focus on individual security selection. At the same time, investors should maintain flexibility to position nimbly and opportunistically in response to changing market conditions — because we expect greater frequency of short-term market sell-offs going forward.
Macro environment: Positive
- In the near term, we have a more favorable view of the prevailing macroeconomic tailwinds than we did in the fourth quarter of 2020.
- Medium to longer term, we have growing concerns around the risk of US Federal Reserve (Fed) “tapering” rhetoric and its potential impact on risk assets.
- Accommodative fiscal policy has helped bolster corporate balance sheets, which is an unusual characteristic of a post-recession economic recovery.
- Increased money supply and stockpiled savings could be unleashed in the months ahead, potentially resulting in a surge in economic activity.
- Since the latest recession was not a balance-sheet crisis, an upswing in activity could translate into real economic growth (not just “repair”).
Corporate fundamentals: Neutral
- We expect global high-yield default rates to trend lower (toward the 2% to 3% range) on the back of supportive fiscal and monetary policy.
- While corporate access to capital remains ample, leverage profiles have been somewhat elevated during COVID-19 — something we will be watching closely throughout 2021.
- The quality of new high-yield issuance has deteriorated; we are seeing a larger number of aggressive leveraged buyouts, questionable business models, and weak structures.
Market valuations: Negative
- The high-yield market rally in January and February was led by “COVID losers” and low-quality issues, compressing spreads inside levels that we would consider fair value.
- The so-called “COVID discount” triggered by the pandemic has been almost entirely recouped; in directly impacted sectors, security selection remains key.
- Market convexity1 is poor amid the mounting risk that inflation and interest rates could rise sooner than many investors had previously anticipated.
- In general, based on recent spread levels, we believe emerging high-yield debt markets offer more attractive value than their developed market counterparts (Figure 1).
Market technicals: Negative
- While technicals are not a strong input into our process, we note that the high-yield market, like other asset classes, has exhibited some troubling risk-seeking behavior.
- Net retail outflows in recent weeks have caused secondary-market liquidity to recede and bid-ask spreads2 (especially on longer-duration, higher-quality bonds) to widen.
Tail risks to watch
- Broadly speaking, COVID risk no longer appears as outsized now that multiple safe, effective vaccines have been approved and delivered to market.
- Structurally, continued central bank support, particularly an active and interventionist Fed, should enable shallower, less punitive credit cycles going forward.
- Inflation remains a big unknown. While we don’t foresee a “hyperinflationary” setting that would crater risk-asset prices, even modestly rising inflation would create some crosscurrents in the high-yield market.
Our high-level message to high-yield investors at this point is to remain vigilant in 2021, seeking to balance a cautious approach with an opportunistic mindset.
1Convexity is a measure of the curvature in the relationship between bond prices and yields. It demonstrates how the duration of a bond changes as interest rates change.
2A bid-ask spread is the amount by which the ask price exceeds the bid price for an asset in the market.