Why One Analyst Is High On High Yield

High yield had a hell of a year in 2016.

In fact, at least as it relates to energy, you’d have been better off in HY credit than in equities:

(Chart: Goldman)

The thing to remember here is that this outperformance came as oil prices put up their best performance since 2009 – WTI rallied nearly 46%.

(Bloomberg)

It seems highly unlikely that crude prices will repeat that performance in the coming year and indeed, the return of US production at $50-$60/bbl could offset some of the momentum from the OPEC production cuts.

Further, HY’s incredible run came amid the highest default rates since the crisis. Those defaults were driven almost entirely by energy and metals & mining. Defaults, the bulls will say, can only go down from here, and besides, in an era of historically low yields, HY will still look attractive.

The idea is that if yields continue to rise, it will be hard for investors to make up their capital losses with coupon payments. That is, rates are still very low historically speaking and so, the only way to effectively compensate for the price declines that will accompany rising rates, is to be in credits that have a juicier coupon. Or at least that’s the line U.S. Bank Wealth Management’s head of fixed-income research Jennifer Vail is taking. Here are some highlights from Vail’s interview with Bloomberg:

High-Yield bonds to outperform in 2017 as Fed Hikes: U.S. Bank
High-yield bonds will outperform in 2017 as investors seek coupons high enough to offset price declines from the Fed’s anticipated rate hikes, Jennifer Vail, head of fixed-income research at U.S. Bank Wealth Management, said in an interview.
“When yields rise, prices fall, and usually a bond’s coupon is enough to offset some of that price decline,” Vail said
“But because yields have been so low for so long, anything with a higher quality is going to have such a low coupon that it won’t offset the decline”
USBWM has put a modest overweight rating on the high-yield bond sector
Expects number of debt defaults to rise next year, but not enough to adversely affect the high-yield sector overall

So the last point there is important. Remember, when we think about spreads we should remember that what happens next year (i.e. how many defaults there are in 2018) will be priced in this year (i.e. spreads will blow out in 2017), just the same as the market priced in 2016s defaults a year early.