Volatility reared its head in the last quarter of 2018, driven by such things as trade tensions, Brexit uncertainty and falling oil prices. In high-yield credit, that meant widening spreads.
Spreads in U.S. high-yield were about 430 basis points early in December, said Nicholas Leach, vice-president of global fixed income at CIBC Asset Management, in a Dec. 6 interview. That’s the widest gap since the end of 2016 and close to the long-run medium, he said. Effective yield was more than 7% at the time, the highest since mid-2016.
Leach, who manages the Renaissance High-Yield Bond Fund, also noted pockets of volatility in high-yield related to fundamentals, mainly within the energy sector, in which he said he had about a 15% exposure.
“Half of that is midstream and downstream,” Leach said. “Those types of companies are not really impacted by the volatile oil prices.”
He had about an 8% exposure to exploration and production companies, and oil field services—underweight relative to the broader market.
Despite being underweight, “it’s important to keep in mind that these are the companies that survived 2016 when oil was below $30,” Leach said, so they’re in relatively better shape to deal with current low oil prices.
He also said high-yield and credit markets more generally are well positioned in a rising rate environment, with the Federal Reserve in the process of rebalancing monetary policy and the European Central Bank expected to reduce quantitative easing toward the end of 2019. “When we look at nominal yields in many areas of Europe, they’re still in negative territory,” he said.
Geopolitical risks such as global trade tensions and associated negative sentiment could alter the expectation of rising interest rates, said Leach. Yet, even if central banks were to refrain from raising rates, “investors in corporate credit and high-yield will still earn that extra coupon carry,” he said.
Federal Reserve meeting minutes from December, released earlier this month, showed officials were prepared to take a more “patient” approach to future rate hikes. The path of hikes is “less clear,” officials said, reducing the number of projected 2019 hikes from three to two. Some private economists think the central bank may raise rates only once this year.
Overall, high-yield is in a better position than it was at the beginning of 2018, Leach said.
As rates rise, he looks for companies that will continue to pay their coupon and improve their credit quality. His portfolio’s high-yield exposure is mostly in U.S.-based companies, he said: telecom, media, consumer products, healthcare, entertainment, and food and beverage.
“These companies are benefiting from the low unemployment [and] the strong consumer confidence, and this means better credit quality for these companies and lower default rates.”
Further, the companies’ credit quality won’t be affected by global macroeconomic themes.
“We’re very confident that these companies will continue to service their debt and actually improve in their credit quality given the strength of the U.S. economy,” said Leach.
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