Recent news has unnerved investors, but we think the story is more nuanced than many suppose.
Last week, a distressed credit mutual fund announced that it was not only closing but would block shareholder redemptions for months as part of a plan for "full and orderly liquidation." The news came at a time of widespread anxiety across all risk asset classes. Commodity weakness and global growth concerns, in addition to the impact of potential rate hikes by the Federal Reserve, have all contributed to volatility and widening of credit spreads. The fund's announcement made matters much worse, and helped drive a 2.6% month-to-date decline (through Friday) in the BofA Merrill Lynch U.S. High Yield Constrained Index. Market volatility indicators suggest that turbulence in risk asset classes is likely to continue over the near term.
With this backdrop, investors are looking for opportunities to find value within risk asset classes. The spread on the high yield index is at 712 basis points over Treasuries, with yield-to-worst at 8.75% (through Friday). At these levels, we believe investors generally are being compensated for the default risk in the market. In addition, despite perceptions to the contrary, liquidity appears to be ample, as reflected in average daily TRACE (OTC secondary market) volume of $11 billion this year, up from $7 billion in 2014.
Looking Toward 2016
Looking ahead, we anticipate U.S. GDP growth of about 2% in 2016, which should be supportive for the overall high yield market. Furthermore, leverage remains relatively moderate and near-term bond maturities have been significantly reduced through refinancing. That said, we expect to see continued periods of volatility. Defaults in the U.S. high yield market are currently estimated at around 1.5% for 2015 and, in our view, could edge up to 3% in 2016, driven primarily by commodity-related sectors. Another uncertainty is future Fed monetary policy. While we anticipate several rate hikes in 2016, our view is that the Fed will take a gradual approach and move slower than many previously expected. In summary, we remain constructive on the high yield market and believe that spreads could tighten, excluding commodity sectors, over the next 12 months.
Keeping the Focus on Fundamentals and Diversification
The events of the past week are certainly important to acknowledge. But it is crucial to also recognize that there are material differences among the portfolio managers and strategies that invest in the high yield asset class. We believe in adding value for investors through a disciplined credit selection process that seeks to avoid defaults and a well-diversified portfolio focused on the large, liquid issuers within the high yield market. With a backdrop of positive economic growth in the U.S, we believe the high yield asset class should provide attractive risk-adjusted return potential for investors.
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