Market Views: Fixed Income
Outlook 2018: Global high yield
Solid credit fundamentals, a moderate uptick in global economic growth with limited inflationary pressure and a favourable supply-demand balance all point to another good year for high yield bonds.
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We believe that the outlook for high yield bonds in 2018 is favourable. Our view is based on solid credit fundamentals, which have improved over the past year, along with strengthening economic growth across most regions worldwide and overall positive technical conditions. However, we do believe returns for 2018 will likely be comprised of primarily coupon income. Despite our lower return expectations, we believe that high yield remains attractive relative to many other fixed income alternatives given its higher overall yield level.
Default rate risk is moderating
We expect the number of companies defaulting on their debt to decline further in 2018, but only moderately so from the currently low level of defaults. The global default rate, as reported by Moody’s, is likely to be in the range of 1.7-2.0% in 2018, which is close to the most historically benign levels ever.
The wave of defaults in the energy and metals & mining industries was a phenomenon in 2015-16 which has run its course and the outlook for many of the remaining companies in the commodity-related sectors has improved.
While there are a few industries facing intense competition and cashflow erosion, such as retail and media, the market is already pricing in a high probability of default for a number of issuers in those sectors. However, we have confidence that the default environment will remain favourable overall outside those areas of stress. This is because so many companies have been proactive in refinancing upcoming debt maturities and extending term loans, so that credit markets are unlikely to seize up and cut off financing to the vast majority of high yield bond issuers.
Fundamentals are stable to improving
Credit fundamentals have been stable to improving in recent quarters, having stagnated previously over the prior 10 quarters. Stronger growth in cash flow as a result of solid revenue growth is helping to reduce leverage and boost companies’ ability to pay debt across the high yield corporate issuer universe.
Reflecting such positive fundamental trends, rating agency activity has been trending positively across the high yield universe in 2017. Upgrades have outpaced downgrades and there has been a better balance of “rising stars” being upgraded to investment grade versus “fallen angels” being downgraded to high yield. We expect such trends to continue into 2018.
Supply is not enough to satiate demand
Another factor that we expect to continue to support high yield in 2018 is negative net supply in the US and modest net supply globally.
While gross issuance may increase in 2018 relative to the high yield bond supply originated in 2017, net issuance after deducting all the debt that will be called, tendered or paid off at maturity date will be insufficient to satiate demand as investors continue to seek yield. In fact, the high yield market is on track to shrink in 2017 due to rising stars, refinancings, maturities and bond to loan migration and this trend could continue into 2018.
In addition to light net new issuance, the supply mix is likely to remain creditor-friendly, with relatively little supply issued for aggressive purposes such as leveraged buy-outs or dividends to shareholders. Instead,the majority of supply will likely be for refinancing, and some supply that could have come to the high yield bond market may instead be refinanced in the bank loan market as we saw this year.
Other positive technical factors, such as light dealer inventories and cautious investor positioning (including elevated cash balances), could lead to further near-term spread tightening and solid returns in early 2018.
Valuations appear stretched but remain attractive versus alternatives
While the global high yield market no longer looks cheap after the sustained rally over much of the past 22 months, high yield bond valuations do remain attractive on a relative basis in several ways.
At a yield of approximately 5.0% and spreads versus Treasuries of +325 bps, valuations for the global high yield index are attractive relative to other asset classes such as investment grade credit, emerging market debt, government bonds, and cash equivalents.
In 2017, many investors were waiting for a market correction to allocate money into the high yield asset class, but a meaningful correction never materialised. Instead, there were three small sell-offs in the market but the widening in credit spreads and the rise in yields were limited in magnitude and short-lived.
In our view, this shows that investors have ample dry power and will seek any modest backup in yields as an opportunity to invest given the ongoing search for yield. This should remain the case as long as credit fundamentals continue to be solid.
Watch for key signposts as market conditions change during 2018
Heading into 2018, we believe that investors should focus on various signposts to indicate whether the risk-reward profile of the high yield asset class remains attractive.
While many uncertainties exist as the new year is about to begin, improving global economic growth should be supportive of credit spreads in at least the first half of 2018. In addition, the market is also likely to benefit from the positive impact of tax reform by the US Congress, although some policy change is already priced in. However, any developments that cause the Federal Reserve or the European Central Bank to back away from monetary policy accommodation faster, or that cause global growth to begin to falter, would be a reason to become more cautious on high yield.
Ultimately, we believe that 2018 will be a year where issue selection will be more important than industry or regional allocation. We expect growing dispersion among issuers in the high yield universe as the winners pick up market share and command pricing power while other companies face headwinds of shifting consumer spending trends and technological disruption. Fundamental research and active risk management in the face of changing market conditions will continue to be key to outperforming.
The full series of Outlook 2018 articles can be found here.
 Credit spreads are the difference in yield between different types of bonds (for example, between government bonds and corporate bonds). Spread tightening occurs when the difference between bond yields narrows.