After being down more than 20% in late March, the high-yield market has continued to move higher in fits and starts and, for the year to date (as at 18 November 2020), is up 4.3% as measured by the Bloomberg Barclays US Corporate High Yield 2% Issuer Capped Index. There are reasons to think this improvement will continue in coming months, but first, let’s take a trip down memory lane.
In January and February, our high-yield outlook was meaningfully negative given valuation concerns. It was coming off one of its best years in a decade, with spreads—the gap in yields relative to comparable maturity Treasuries—stretched tight. It was hard to see high yield being capable of adding much value at these levels. The good news is we put most of our money back to work in the market, lightening our underweight to high yield in our US-based multi-sector portfolios, after the sharp pandemic-driven sell-off in March—and before the high-yield market took off with a 10% return in the last week of that month.
Given anticipation of historically weak second-quarter GDP (which we got, with its worst-ever annualised contraction on record), continuing coronavirus concerns and a contentious election cycle, we expected another pullback and with it a better opportunity to go overweight. Unfortunately, that opportunity didn’t materialise. We did, however, recently shift to neutral from our modest underweight for the following reasons:
- A US economy that has delivered stronger-than-expected performance: as steep as the pandemic recession was, the bounce-back has been record-breaking, recovering more than two-thirds of the contraction so far. Most companies have adjusted well to virus-related constraints and, while many remain in negative territory, are heading in a positive direction.
- Light at the end of the tunnel: although we made our neutral call before the euphoria over Pfizer’s vaccine announcement, we expected that every day that passed moved us closer to that event despite the surge in COVID-19 cases. In mid November, we got an added catalyst with Moderna’s announcement of a potentially more effective vaccine.
- An election that largely has been resolved: this particularly contentious election cycle presented an additional level of uncertainty.
- Default rates that likely have peaked and should be lower in 2021: many of the zombie companies responsible for most near-term defaults already are priced at steep discounts, with the markets having absorbed those losses. Historically, big upticks in defaults result in a better-quality high-yield market and lower default levels.
One caveat to our lower default rate call: the Energy sector, which has contributed a disproportionate number of defaults in 2020. Because of the large number of Energy companies downgraded from investment grade to high yield in March, that sector has increased as a percentage of the high-yield market. These companies tend to be larger and have better-quality assets. But another big drop in oil prices—back to the high $20s or low $30s per barrel—could result in another uptick in Energy-related stress.
What we’re watching
- Likelihood of a divided government: the Georgia Senate runoff elections will be the determinant. A Democratic president with a divided Congress appears to be the most likely outcome, reducing the possibility for sweeping policy shifts and tax increases. The result would be a more “business as usual” environment with more incremental changes in the Energy and Health Care sectors (fewer immediate restrictions for oil producers and frackers, for example, and avoidance of single-payer health care). And that presents a reasonably positive backdrop for high-yield companies overall.
- Progress in defeating Covid-19: a Biden administration will encourage a more robust response to the Covid-19 surge, but we think a second shutdown is unlikely. Key will be vaccine efficacy, public acceptance and distribution.
- Greater incentives for alternative energy usage: this will affect coal and fossil fuel companies, but over an extended time frame. We have been positioning for what we believe is an inevitable move toward greater sustainability in energy use for quite some time.
- Opportunities for bipartisan agreement: a bipartisan stimulus package, albeit likely less substantial than the one originally proposed by the Democrats, would provide support for those being impacted by the virus and would help the Health Care sector deal with the impact the virus is having on the overall health care system. An agreement on a comprehensive infrastructure plan would benefit the Materials and Industrial sectors. Also, while drug price reform will again be topical, the final bill is expected to be less draconian than originally anticipated for the pharmaceutical industry.
The main reasons we’re not overweight high yield at this time is that yield spreads between high-yield bonds and comparable Treasuries have aggressively tightened since their March lows and currently are on top of historical medians. In addition, we expect a difficult surge in Covid-19 cases this winter with vaccine relief—and a substantial lift to the economy—not likely until summer 2021. Nonetheless, although returns may be modest relative to the past few years, we believe a selective high-yield portfolio will likely be one of the better places to invest in the fixed-income world.