U.S. government bonds took a hit as yields spiked sharply in the wake of Donald Trump's election as president of the U.S., although high-yield bonds suffered somewhat less. Whether there is more pain to come is a guessing game, as Trump's promised measures to slash taxes and spend heavily on infrastructure will force yields higher still.
Although some portfolio managers of high-yield bond funds are upbeat that the asset class looks more promising now, others are cautious about prospects.
"I don't think things will get that much more challenging," says Harley Lank, vice president with Fidelity Investments Asset Management, a unit of Boston-based FMR LLC, in Boston and portfolio manager of Fidelity American High Yield Fund. "In general, high-yield bonds are less sensitive to changes in interest rates than are longer- duration, investment-grade or treasury bonds, although [high-yield bonds] are not immune. But rising rates mean that things are improving in the economy. Generally, that means good things are happening for non-investment grade companies. Over the intermediate to longer term, rising interest rates portend good performance for high-yield bonds."
Lank's base case is that high-yields' spreads over treasuries will continue to compress for the next year or so. The spread now is 412 basis points (bps) over treasuries, vs 550 bps last summer. "Back then, we were around the long-term average. Now, we are inside the long-term average," says Lank. Looking ahead, however, he is optimistic: "I would not be surprised if spreads were 50 bps tighter within the next year."
If Trump's policies are accepted by Congress, Lank believes, certain companies stand to benefit: "You will see the default rate continue to drop, the gross domestic product (GDP) growth rate will accelerate, inflation expectations will increase and interest rates will continue to tick up. In that scenario you want to be at the lower end of the credit spectrum." He notes that B-rated and CCC-rated bonds will benefit from an improving economy and will be less affected by rising rates because of those bonds' higher coupons. "At the margin," he adds, "I am getting a little more aggressive."
Rather than make wholesale strategic changes, Lank has been reducing the Fidelity fund's holdings of some of the very low-yield bonds and is investing in positions that have improving fundamentals and are attractive total returns opportunities. "In some cases, I've been increasing the exposure to energy names and telecom names, for which the story continues to get better."
High-yield bonds account for 90% of the Fidelity fund's assets under management (AUM). There also is 7.5% in senior secured, floating-rate loans and 2.5% in cash.
From a sector standpoint, energy is the largest weighting, at 14% of AUM. There also is 10% in telecom, 9% in banks and thrifts, and 9% in health care, plus smaller weightings in sectors such as technology. The average duration of the Fidelity fund is 3.6 years, vs four years for the benchmark Bank of America Merrill Lynch U.S. high-yield master II index.the problem is that the bond market has priced in almost total success in Trump's policies to stimulate the U.S. economy, says John Addeo, senior managing director and chief investment officer of U.S. fixed-income at Boston-based Manulife Asset Management (U.S.) LLC and lead portfolio manager of Manulife Global Tactical Credit Fund. He shares portfolio-management duties with Dennis McCafferty, managing director at Manulife.
"Like the equities markets, the credit market has priced in an element of success that needs to be delivered upon. But we may not see results for nine to 12 months. Execution risk is very high right now," says Addeo.
Trump may be unable to deliver on his promises or the timetable may be much longer than the market anticipates. Because the market interprets Trump's agenda as being inflationary, Addeo notes, "the government bond market priced in increased inflation expectations."
Adds Addeo: "Corporate bonds are more impacted by the fundamentals. If Trump is successful with plans meant to stimulate the economy, then the underlying corporate fundamentals will improve and creditworthiness should get better. Therefore, credits are stronger. That's why we've seen the difference in performance of government bonds vs credit, which have spreads embedded in them."
Addeo notes that the benchmark index's yield has slipped from 6.45% from 6.3%. He argues that the market is leaning too far to the upside. "The market is pricing in a 2.5% default rate for 2017. That's the biggest risk in the high-yield market," says Addeo, adding that the market is pricing a recovery rate of 40¢ on the dollar in the event of a default. "Doing the math, the market needs to get compensated by about 300 bps of extra spread in addition to compensation for default risk. That tells us the market is fair to slightly overvalued."
The concern is that spreads over treasuries are unlikely to compress significantly from where they are. "Historically, the market has not spent much time when spreads are at or lower than where they are today," says Addeo, adding that the business cycle is long in the tooth. "At this point, there is a greater likelihood, in terms of a range of outcomes, for spreads to be wider than narrower."
Addeo was cautiously positioned before the U.S. election, and he maintains that stance: "We will make some changes over the next quarter to get more defensive, but we're pretty defensive to begin with."
About 74% of the Manulife fund's AUM is in high-yield bonds, with 22.5% in investment-grade and about 4% in cash.
On a geographical basis, about 22.5% of AUM is allocated to Asia, 50% to the U.S. and 27.5% to developed and emerging markets in Europe and Latin America. The average duration of the fund is four years, vs 4.5 years for a blended benchmark of the Barclays global high-yield total return index (C$) and Barclays global credit corporate total return index (C$).
The path of interest rates clearly is upward, says Sergei Strigo, head of emerging market debt and currency at Amundi Asset Management in London, U.K., and portfolio manager of Excel High Income Fund.
"The question is how quickly [rising rates] will happen, and to what extent," says Strigo. "There is quite a lot of uncertainty at this stage with regard to the path of economic growth in the U.S., the size of the fiscal stimulus and how inflationary the stimulus will be."
The Excel fund is dedicated to emerging markets' (EM) bonds that are considered part of the overall high-yield universe.
Strigo notes that the U.S. dollar (US$) has appreciated against all emerging markets' currencies. "This has counterbalanced some of the potential positive feedback from the growth due to the fiscal stimulus that we may see in the next year or two. In a sense, this is a kind of monetary policy tightening," says Strigo, noting that the bond market is trying to determine the direction in which U.S. interest rates are moving.
Still, the spread over EM bonds has narrowed lately by about 30 bps, compared with the 80 bps that occurred following the election.
Strigo does not anticipate further dramatic interest rate hikes: "From current levels, believing that rates will increase significantly and that we'll see significant increases in bond yields in the next few months is very difficult.
"We have to keep in mind," he continues, "that interest rates have gone up already in the U.S., and will probably move up further. As long as [the rise] is orderly and slow, EM can do relatively well. We still are in an environment of extremely low yields in the developed world. The U.S. is the only country [in which] rates are going up meaningfully. We don't expect interest rates to go up in Europe or Japan."
Strigo points to macroeconomic issues such as Brexit and forthcoming elections in Germany and France, which may feed anxiety in investors who use bonds as a safety net. Says Strigo: "There are enough risks to the downside, which means that interest rates will stay low. All of this is quite beneficial for EM bonds. That's why credit spreads have not widened really significantly since Trump's election. Globally, there is a lack of high-yielding securities. EM debt is quite attractive."
Strigo is bullish largely because many EM economies are improving and bond yields tend to be higher than in the developed world. The Excel fund invests in about 40 countries: Brazil is the largest country weighting, at 12% of AUM, followed by Mexico (7.5%), Russia (7.5%) and Indonesia (6.8%), with smaller weightings in countries such as Argentina.
More than 50% of the Excel fund's AUM is held in investment-grade bonds and 40% is in high-yield bonds. Ninety per cent of the portfolio is held in government and state-owned enterprise debt, plus about 10% in corporate bonds. The fund's average duration is 5.7 years, vs 5.6 years for a blended benchmark of the hard currency-oriented JPMorgan EMBI global diversified index and local currency-oriented JPMorgan GBI EM global diversified index. About 60% of the fund's currency exposure is in US$ and euros, with the remainder in local currencies.
Strigo is precluded by compliance policies from discussing specific holdings, but says he is constructive on Latin America: "There has been significant political change in Brazil and Argentina, especially with new administrations taking over. That's resulted in positive momentum in both countries. At the same time, we see a lot of value in their bonds. Argentina is a story of hard currency debt, both sovereign and provincial bonds."
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