US high-yield bonds have experienced a blistering start to 2019. The return of 2.6% is the best start to the year since 2009. The upswing has been enough to erase the 2.3% loss investors endured in 2018. And spreads to risk-free government bonds have tightened 68 basis points (bps), an encouraging sign of improving market sentiment.
But while we view the revival in high yield as a positive signal, we see it largely as a recovery from excessive pessimism and technical headwinds from late 2018. Any further rally in high yield is likely to be limited and more gradual.
- New sales of high-yield bonds remain dormant, pointing to weak demand from investors. While rating agency S&P is expecting USD 8.5bn of new issues in the pipeline, investors would be wise to wait for the primary market to come back to life before increasing exposure to high yield.
- Further volatility in US Treasury yields could cut short the rally in high yield bonds. Investors experienced a widening of spreads when Treasury yields were falling, amid broader market risk aversion, and the spread tightened as UST yields started to rebound. With a range of risks still plaguing markets, a renewed pickup in Treasury volatility would be negative for the asset class.
- The weak performance of high yield in December was partly due to the weakness in the oil price, with the energy sector accounting for about 15% of the US market, and to low levels of liquidity in the run-up to the holiday. We believe the rebound from these exceptional conditions has already largely run its course. WTI crude prices are now trading at USD 51/bbl, from a December low of USD 42/bbl. That puts WTI crude above the upper end of the USD 45–50/bbl range at which high-yield energy issuers are profitable.We still see some room for US high-yield credit to advance. With defaults likely to remain below 2% in 2019, we believe a spread of 420–460bps is appropriate, versus a spread of around 465bps at present. However, any further improvement is likely to be more incremental. Still, the current yield around 7.5% is offering decent income and we keep a neutral allocation.
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