2017 Outlook: Solid tailwinds for high yield

12-16-2016

Following a year when high-yield bond returns far exceeded expectations, our outlook for the asset class remains strong for 2017. Although returns may not reach 2016 levels, high yield will likely be one of the better places to invest in the fixed-income world. Here’s why:

  • Economic and credit conditions are favorable High-yield bond outlooks always start with the economy, which we believe will continue on a steady pace with the possibility of a “Trump Bump” leading to gross domestic product growth above that of the last few years. Credit conditions should remain stable as well. We expect default rates to fall as distressed conditions in the energy and commodity-related sectors have substantially eased and because non-commodity sectors will continue to experience low defaults in 2017.
  • Technical factors are supportive While debt leverage is somewhat elevated, interest coverage—companies’ ability to pay their interest expense—is strong given low rates. The ability to refinance debt at ultra-low rates and extend maturities has allowed many firms to restore and build their financial health. Additional factors supporting high-yield issuers: Free cash flow generation is healthy; a resurgent equity market opens up a venue for credit-enhancing equity issuance; and conditions are favorable for merger & acquisition activity to pick up. New issuance declined in 2016 and likely will fall again in 2017. At the same time, we expect high-yield demand to be robust, driven by 2016’s strong returns, negative rates in much of Europe and increased interest in the U.S high-yield market by investors looking to hedge against rising interest rates. 
  • Valuations a potential red flag but not overwhelmingly so Current valuations do suggest a measure of caution going forward. Credit spreads—the gap between high-yield bonds and comparable-maturity Treasury bonds—opened 2016 at 750 basis points, topped 900 basis points by early February, then by mid-December had fallen to just under 500 basis points—below the historical median spread of 534 basis points. That being said, credit spreads typically bottom in the low 300s, so there is still room for credit spreads to tighten, which we believe will happen in 2017. Over the course of next year, we expect U.S. Treasury rates to rise modestly from today’s levels, with tightening high-yield spreads at a minimum offsetting the rise in Treasuries. That sets the stage for modest capital appreciation along with a still-attractive coupon return.

The case for high-yield bonds remains intact
In sum, factors in support of high yield continue to outweigh concerns. As a result, we think investors should continue to benefit from an overweight allocation to this asset class—albeit at a more modest level than in 2016.