Tom Ross, corporate credit portfolio manager, looks at the outlook for high yield bonds in 2020
- Credit spreads are likely to be determined by the direction of global growth. We do not believe growth is likely to stage a recovery at this point but clearer signs of fresh vigour in the economy could cause us to soften our stance.
- Political risk remains high in 2020 – a US presidential election year – which could have big implications for certain sectors depending on who wins the presidency.
- The search for yield should continue to generate demand for high yield bonds.
What is the key factor you are looking out for in 2020?
A key question for us is whether we will see spread compression (tightening) in 2020 that could lead to high yield bonds with wider spreads outperforming. We are currently positioned with a neutral beta position, composed of a small overweight to bonds we classify as ‘higher return potential’ and an underweight to ‘core stable income’ positions. If global growth data improves or some of the geopolitical uncertainties currently plaguing markets diminish, we may look to increase the overweight to higher return potential positions, and also purchase preferred opportunistic ideas, largely through issuers which have encountered credit spreads widening in 2019. That said, any risk additions we make will be selective and made with an awareness of avoiding adding too much exposure to cyclical areas given the fragility of the global economy and the risks inherent in more highly leveraged bonds, such as in the US energy sector, where some of the widest spreads currently exist. There are some glimmers of hope that the slowdown in economic growth could be bottoming but we would need more data over coming months to determine if the global economy has reached an inflection point.
What is the biggest risk to high yield?
There are plenty of hurdles that the market will face in 2020 and the biggest of these are likely to be politically driven. While the result of the general election in the UK means a more market-friendly government and reduces uncertainty, the issue of what a future trade deal between the UK and the European Union looks like is still up in the air and could lead to volatility later in 2020.
In the US, the run-up to the presidential election is also a potential risk as the Democrats are fielding candidates with policies that could have big implications for certain sectors, whether that is banning fracking on federal lands in the US (around 11% of the global high yield sector is energy-related issuers1), or changes to the healthcare or drug pricing system that could impact healthcare and pharmaceutical companies. We welcome the agreement of a phase one trade deal between the US and China, which was formally signed in January, but we are also cognisant that President Trump is determined to make political capital out of trade, so we can probably expect more volatility around the subject during the election campaign.
Where do you see opportunity in 2020?
We believe that investors will continue to search for yield in 2020 as we expect most major central banks to be holding rates low, with some engaging in quantitative easing. The European Central Bank is committed to its corporate sector purchase programme, which effectively creates a price-insensitive buyer for investment grade corporate bonds and is likely to result in a trickle-down effect on high yield demand. With yields staying low, companies should be able to refinance at low costs so we anticipate defaults staying low versus historical levels, albeit picking up marginally as global growth remains lacklustre.
Regionally, we think Europe looks the most attractive on a risk-adjusted basis and is likely to be technically supported by the European Central Bank’s corporate sector purchase programme. In terms of sectors, we favour real estate given that the bonds are backed by real assets with relatively robust income and fundamentals in the sector continue to improve. Relative weakness in emerging market corporates in 2019 has created an opportunity to add risk in that region too.
Global high yield spreads closed 2019 around their three-year averages so there is some room for tightening, although on a five or ten-year basis they are tighter than their averages.2 Spreads could grind tighter if the global economy improves, giving the market more confidence around earnings and cash flows.
1Source: Bloomberg, ICE BofAML Global High Yield Index, constituent weights at 31 December 2019.
2Source: Bloomberg, ICE BofAML Global High Yield Index, spread to worst versus government, as at 31 December 2019. Past performance is not a guide to future performance.