US high-yield market poised for growth

Fabrizio-Palmucci-Source-2016-CUT

Investors who have an allocation to high yield in their portfolios should be encouraged by the strong recovery of the asset class in recent weeks, especially following poor performance earlier in the year. Conversely, those who have stayed on the sidelines may be wondering if the opportunity has passed them by. We think the rationale for investing in high yield remains intact and, within the broad asset class, investors should be focusing on US high yield with maturities of up to five years, given the current shape of the curve.

Some investors may still be wary of the headwinds that potential US rate hikes pose to bonds in general. It may not be quite as clear-cut now as it once was, but the Fed is still likely to raise rates two or three times before the end of the year, especially if global conditions continue to improve. If that’s the case, investors may want to focus their attention on shorter durations, which are less sensitive to changes in interest rates. The good news for investors is that, in current market conditions, they would not be compensated for taking on term risk anyway.

Looking at the oil price – another concern for some investors – we see mixed fortunes for some companies. When oil was trading below $30 some investors fretted about its impact on companies in the energy sector and the potential that any distress could infect the rest of US high yield. The sector accounts for some 12 per cent of the broad high yield universe but companies in the midstream and downstream segments are not nearly so correlated with the oil price and, as such, are generally not in distress.

UShighyieldcurve

As for contagion, history has shown us that distress in one area rarely has much of an impact on the broader market. The main exception was the financial crisis, because of the wide-reaching effect that tighter credit conditions had on companies in all sectors. The opposite may be the case for oil. Most companies actually benefit from lower oil prices, so we don’t think this should be a worry.

More generally, some investors may think that an environment of wide spreads between high yield and government bond yields will be followed by an increase in defaults and, in turn, lower total returns for the asset class. However, evidence suggests that markets tend to overestimate future defaults and therefore overcompensate investors.

The ETF market in Europe offers exposure to US short-term high yield mainly via passive approaches. Ones that use filters may be able to avoid individual issuers where the investor is not being adequately compensated for the amount of default risk taken, meaning they may be able to reduce overall volatility without sacrificing yield.

Since parts of the high yield market are not very liquid, and the universe comprises thousands of names, you may want to choose a fund that filters out the most illiquid issues, as well as screening for credit impairment. By doing this, it’s possible for the fund to reduce transaction costs as well as exposure to distressed names, such as some of the exploration and production and oilfield equipment and services companies.

Some ETFs also optimise the filtered portfolio to match key benchmark characteristics, including duration and spread. What does all this mean for investors? They are better able to select an ETF that provides them with the exposure, and the profile, to meet their objectives and view of the market.

Fabrizio Palmucci is a fixed income specialist at Source