Though the remarkable start to 2018 seems like a distant memory (ironically
just two weeks into February) given the recent route of global markets, let’s
recap. January was a great month for risk assets, while less than stellar for safer
alternatives. U.S. stocks returned an impressive +5.7%, bested only by emerging
market equities, earning near 8%. Enthusiasm over tax reform and its impact on
corporate earnings boosted the former, while mounting calls for synchronous global
growth (and a weaker dollar) juiced the latter. Though high yield bonds failed to
keep pace, the result of already-rich absolute valuations and headwinds from rising
Treasury yields, the +0.60% market return and +1.96% return for higher beta (CCC
rated) bonds were respectable nonetheless.
Importantly, average spreads of high yield debt tightened -32bps through January
26th (effectively absorbing the ~30bps rise in 5yr Treasury yields), setting fresh
tights for this cycle (311bps vs. the 323bps set in June 2014). In our view, this left
valuations of high yield bonds 32bps less compelling than the already uninspiring
risk/reward on offer to start the year. With spreads setting post-crisis tights entering
the tenth year of this cycle combined with a deafening calm in the marketplace
for the better part of January, investor optimism and complacency seemingly
had reached a peak, and our call for caution and defensive positioning felt ever
appropriate…
Risk Assets Posted Solid Returns to Open 2018
Led by a “Melt-Up” in Global Equities
Source: BofA Merrill Lynch Global Research
Market Performance
As discussed on the previous page, the exuberance in global risk
asset markets carried high yield bonds to a respectable +0.60%
total return in January. More impressive, however, were excess
returns (total return less the drag from equal duration Treasuries)
of +1.49%, the best performance since December 2016.
High Yield Bonds Generated Solid
Excess Returns for the Month
Source: Barclays
Exuberance over the current state of underlying business and
global macro fundamentals, combined with a growing concern
over the path of interest rates, encouraged a still very sanguine
investor base to rotate out of lower yielding, higher quality
bonds into higher nominal yielding, lower quality credits. The
technicals created by this momentum, in addition to the higher
empirical interest rate duration of BB rated bonds vs. CCCs, led
CCC rated risk to outperform in a fairly meaningful way. Indeed,
CCCs earned a total return of near 2% while BBs effectively
broke even as more modest spread compression and coupon
earned just enough to combat headwinds from the ~30bps rise
in Treasury yields.
Source: Barclays
While the rotation into more levered capital structures (CCCs)
was a clear signal of the risk-on psychology, sector selection
offered further affirmation. Last year’s trash (at least the
second half of last year) was January’s treasure as structurally challenged battleground sectors and credits generated stellar
gains. Drillers (service providers to the onshore and offshore
oil and gas E&P industry), were the best performing credits
as the rising tide of higher oil and gas prices lifted all boats.
With spot WTI and Brent prices rallying to $65/bbl and
$70/bbl, respectively, a largely under-exposed investor base
scrambled to add sector beta. Away from Energy, Wirelines
were (briefly) back en vogue, specifically industry bellwether
Frontier Communications, which saw its bonds rally across
the term structure +5-12pts on the back of news the company
was seeking an amendment to its credit agreement, which
would permit it to issue additional liens on its assets (thereby
increasing its optionality to stay an inevitable restructuring
for a couple more years). Finally, hospital bonds (notably the
unsecured debt of highly levered operators Tenet Healthcare
and Community Health Systems) were big outperformers this
month as beaten-down investor expectations for utilization
trends inflected positive (influenced by an aggressive flu season)
and company specific catalysts skewed favorably – Tenet
indicated it would pursue strategic options to deleverage its
balance sheet, while Community suggested it was close to an
agreement with bank lenders that would enable the company
to address its near-term maturities. Underperforming on the
month were generally high quality sectors (cable, packaging,
etc.), which were caught at the epicenter of technical (risk
rotation, negative fund flows), macro (rising interest rates) and
idiosyncratic (in the case of cable, Altice’s international credit
silos suffered after the company moved to spin-off its more
stable U.S. business lines) pressures.
Source: Barclays
Green Text= Best Performing; Red Text= Worst Performing
Market Technicals
Fund flows were mixed week-over-week in January, as net inflows
during the first two weeks, concurrent with the global risk-on
trade, inflected sharply negative in the back half of the month
(and this negative momentum has carried aggressively into
February). High yield funds, both ETFs and mutual funds,
realized net outflows of -$2.4bn to start the year, coming on the
tails of -$18bn net outflows in 2017. While the spike in volatility in stocks and Treasuries has accelerated the exodus from high
yield thus far in February, the impetus for the outflows in January
is clear – interest rates. To be sure, both equity and loan funds
saw positive inflows in January, signaling the rotation out of high
yield stemmed from fears of rising inflation and interest rates
rather than concerns over corporate fundamentals.
Fund Flows Quickly Inflected Negative as Concerns Over
Rising Rates Weighed on Sentiment
Source: Lipper, JP Morgan
The primary market was slow to start, but volumes ramped
exponentially as the month progressed. USD-denominated
issuance totaled $24bn in January, the most active start to
a year since 2013. Two themes dominated the calendar this
month. First, high quality issuers clamored to opportunistically
raise capital at historically low (sub-5%) all-in costs given
expectations of rising interest rates (indeed, as we write today,
only a select few 8-10yr high yield bonds still yield less than
5%). Second, the industry composition skewed heavily towards
commodity-levered issuers (near 50% of issuance), particularly
land and offshore drillers, that were gifted a window to access
capital (from a risk-seeking investor base) amidst the rising
commodity tape.
Source: Barclays
Green Text= Best Performing; Red Text= Worst Performing
Fundamental Trends
January high yield default activity was benign with only one
issuer, Exco Resources, defaulting on a little over $200mn of high
yield bonds. This brought the trailing 12-month par-weighted
default rate (per JPM) to 0.99%, back to the mid-2014 lows of
this cycle. With very little stress (or distress) priced into capital
structures today – average CCC rated debt yielding just +634bps
over Treasuries and less than 6% of bonds with risk premiums
in excess of 1,000bps – the impetus for rising default activity, at
least for the time being (as this can correct swiftly), is low.