In this interview, Portfolio Manager Seth Meyer, CFA, discusses some of the factors that are influencing the U.S. high-yield market.
Q: How late-cycle is the U.S., and how does this impact your view of credit quality?
Seth Meyer: Since the Second World War, the average economic expansion in the U.S. has lasted around 60 months. The current expansion has already lasted 96 months, leading us to believe we are much closer to the end of the business cycle.
Age of post-WWII economic expansion in the U.S. (months)
As we conduct our fundamental, bottom-up credit research, we emphasize two key things: management teams focused on deleveraging and companies with free-cash-flow generative business models. When valuations get tight and we are near the end of the credit cycle, we are looking for stability of free-cash- flow generation. Our approach to quality is less about emphasizing higher-rated high-yield securities, and more about identifying what we believe to be higher quality business models. In this environment, we typically find names in less cyclical sectors to be attractive.
Q: Has faith begun to fade in an extended economic and credit cycle under President Trump?
SM: In our view, the most accretive economic event that President Trump could carry out is corporate and personal tax reform. However, the hurdle is clearly higher now than it was in November 2016, and the administration’s inability to-date to execute on the repeal and replacement of the Affordable Care Act creates doubt about Trump’s ability to accomplish any reform legislation, whether in health care, taxes or infrastructure spending. That said, Trump has more cross-aisle support in Congress for tax reform than he does for health care reform. We believe that if the administration can accomplish tax
reform, particularly corporate tax reform, the cycle can be extended. Failure to execute even a watered- down version of tax reform would likely cause investors to lose faith in the administration’s ability to extend the cycle.
Despite distractions and the administration’s lack of accomplishments thus far, the insatiable demand for yield, in combination with positive gross domestic product (GDP) and employment growth, relatively strong company fundamentals and the potential for tax reform, creates ongoing investor interest in high yield. Spreads will likely widen if we see recessionary pressures or a turn in GDP, but we see markets expressing extreme complacency that such an event will not happen right now.
Q: Although high yield is less sensitive to rate risk than investment-grade credit, does monetary tightening by the Federal Reserve (Fed) pose any risks?
SM: Fed tightening puts the most pressure on the front end of the yield curve. However, it typically leads to volatility in longer duration assets (including the five-year part of the curve, which high yield is most exposed to) and the most interest rate sensitive sectors. As you look lower down the ratings quality spectrum, issuers will be less correlated to a rate hike. With BB-rated bonds (nearly 50% of the high-yield market as represented by the Bloomberg Barclays U.S. Corporate High Yield Bond Index) the most correlated to moves in interest rates, we expect a component of interest rate sensitivity as the Fed tightens but not to the same degree as we would see in investment grade.
Q: Does the Fed’s tightening raise your interest in financials?
SM: The most recent tightening does not raise our interest in financials, as financials tend to perform well with a steeper yield curve. At the moment, the dampened outlook for growth and inflation is leading to a flatter curve, creating an unfavorable environment for financials. If, however, the Trump administration manages to successfully implement growth-enhancing reforms, the back end of the curve is likely to sell off, and then we would find financials attractive. In such an instance, the Fed would be behind the curve. It would take them a lengthy period of time to catch up, so we would expect financials then to benefit from a steeper curve for some time.
Q: Do any sectors look more attractive or less attractive, and why?
SM: We are looking for companies with stable free-cash-flow profiles. Cable communications and food and beverage issuers are attractive at this juncture, as are health care issuers, specifically hospitals. The societal need for hospital services leads to these asset-rich entities being strong risk-adjusted opportunities, in our view. Some are selling assets; others are diversifying business models out of the pure acute care hospital and into higher margin businesses such as ambulatory surgery centers.
Furthermore, most U.S. hospital issuers have opted to conserve capital and pay down debt as they consider the implications of still-undecided health care reforms.
We are less focused on retailers, including fast fashion and most department stores, that are facing challenges as consumers shift their shopping online.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the US dollar-denominated, high yield, fixed- rate corporate bond market.
Bond ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest)
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Yesterday crude oil made fresh lows for 2017 and its YTD performance is now a negative (19.8%). It is weighing on the broader commodity class and related tracking instruments as crude makes up ~12% of the Bloomberg commodity index (BCOM). After five straight down years from 2011 to 2015 with average annual declines of (13.5%), the BCOM index appeared to be emerging from a vicious bear market in 2016 when it rebounded 11.4%.
However, 2016 is looking more like a bear market rally as this year’s rout in oil, along with a range of other commodities like natural gas, soybeans, sugar, corn and coffee, have driven the BCOM index to a YTD decline of (8.9%). Last week the BCOM broke a nine-month support level at 82 and this week is seeing downside follow-through. MTD it is down (3.7) for its worst monthly decline since July 2016. The weekly RSI is making 15-month lows at the current 33 level, while the next the next obvious support level is down another 3.8% at 77. This year’s deflationary price action is occurring as the Federal Reserve just raised the overnight lending rate three times in six months, along with recent projections to taper the balance sheet and another rate hike in the second half of 2017. Barring a turnaround in crude and the broader commodity complex, one has to wonder whether or not the Fed will need to taper its own forecasts.
As of 12:30PM:
US stocks are mixed this morning, while Biotechs (+1.3%) continue their recent surge. Yesterday’s EIA report initially gave Oil prices a boost, but a late day sell-off put the price per barrel at its lowest level since November. Gold is higher for the 2nd straight day, a streak the precious metal hasn’t posted in 2 weeks.
The S&P500 (ES) edged lower yesterday as it forms a 3rd straight weekly Doji. Although the ES has been the strongest of the index futures on my Watchlist, trading just under 2017 highs, the ES sits vulnerable to profittaking from just below upchannel resistance (on the daily chart). While there is still a chance the ES will again power higher off the 4hr chart's uptrend support, I'll be patiently waiting for a break lower, and when it happens, I'll begin to look to go short. The daily and 4hr RSI, Stochastics and MACD are sliding lower or consolidating recent losses. Ideally, I'd like to short in the red zone (of the daily chart), targeting the green zone for mid next week. The amber/yellow zone is where I might place a stop if I was a swing trader (although in my personal account which I seldom hold overnight I set my stops tighter).
S&P500 (CME ES Sep17) Weekly/Daily/4hr/Hourly
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