During the first week of January, we shifted our tactical allocation strategy into high yield bonds. This positioning marks a return to high yield from the defensive posture BTS assumed in late fall.
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 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 is at about 2.5%. If we view this level in relation to its 52-week range (2.06-2.61%), the yield is about 20% above its low and 5% under its peak.
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 moved significantly over the October 2017 high. In the process, high yield bonds have not shown the typical correlation with stocks. 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 reports at higher readings, together with the 0.3% gain in wages in the December employment report, may be a catalyst that pressures yields to the 2.61% 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 yield curve based on the 10-year note to the 2-yr note is 50 bps—down from 1.25% a year ago. The US dollar also weakened last year by about -7%. 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.
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.
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. There is no guarantee that the strategies discussed will succeed in all market conditions or are appropriate for every investor.
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