UBS: Outlook for High Yield - Another year of carry

–   In an environment of gradually rising interest rates, we believe High Yield (HY) can perform well

–   We regard HY as fairly valued and expect returns in 2018 to be driven largely by coupon and carry

–   Given the strong global outlook, an increasingly well-capitalized banking system in the US and Europe, and continuing high levels of corporate debt re-financing, we do not foresee any significant deterioration of credit in 2018

Reflecting on the past year, 2017 was a year of low volatility (1) across risk asset classes with both US and EUR High Yield posting high single digit total returns (2) that were above most of the Street expectations. Our forecasts for 2017 returns (3) were closer to the actual returns than many of the Street forecasts. Default rates were low (4)  and, in contrast with the 2016 Energy sector issues, there were no major sector themes and worries. Overall 2017 was a year where ‘risk on’ dominated and higher beta industries and lower rated sectors outperformed.

Geopolitical risk was a theme running throughout the year, however the market impact of these successive events became less and less as the year progressed. Early 2017 was dominated by concerns of a possible populist win in the upcoming French election and uncertainty surrounding US policy following President Trump’s election. In March, as expected, the UK government triggered Article 50, formally starting the process to leave the EU. In the Summer tensions surrounding North Korea led to a brief spread widening, as did tensions in Catalonia later in the year.

Global central bank policy remained supportive to credit markets, with the US Federal Reserve continuing a measured series of rate increases which were well communicated to the market. The appointment of new Fed Governor Powell was seen as marking policy continuity at the Fed. Given the increasing evidence of sustainable growth in the Eurozone, the ECB began reducing its bond buying program. First the ECB reduced purchase volumes from EUR80bn to EUR60bn per month. Then in October the ECB announced that volumes would reduce to EUR30bn per month from January 2018 and that the program would continue until at least September 2018. Similar to the Fed’s path of rate hikes, these moves were well flagged, reducing their market impact. Also the levels of corporate bond purchases remained relatively stable through the year. 

Technicals remained supportive, with subdued net supply in both US and EUR high yield. There were continued high levels of new bond issue proceeds being used by issuers to refinance debt and extend debt maturity profiles. Over the past couple of years the Loan market has provided increased competition to the high yield market for issuers’ funding requirements. This has been most pronounced in the single-B part of the market. The Loan market has become increasingly ‘Covenant-lite’ – thus offering issuers with less restrictive terms to borrow money. These aggressive lending conditions in the Loan market partly reflect large recent investor inflows into Loan funds as well as very high levels of CLO issuance.

In November there was a brief period  of spread widening (5)  driven by events at a relatively small number of credits in the Telecommunications and Healthcare sectors. One dozen names accounted for roughly half the spread widening. Although the magnitude of the volatility was not that great (c.25 bps spread widening), it had a disproportionate impact on market sentiment given the relative calm of the year up until that point. We viewed this as an attractive opportunity to add risk to portfolios.

The big macro-economic surprise  for the year was the strength of the Eurozone economy, in both the core and periphery. The US economy continued to strengthen and in both the US and Europe inflation data remained significantly below market expectations.

Read the full Outlook here.

References

1) VIX 31 December 2017
2) ICE BofAML 31 December 2017
3) UBS Asset Management “Outlook for High Yield, Another year of carry” January 2017
4) Moody’s 31 December 2017