The rally in US high yield has continued despite signs that the credit cycle is turning and fundamentals are deteriorating. Michael Goldstein, co-head of GSAM's High Yield team, discusses the pros and cons of holding high yield in this stage of the credit cycle.
We think there is ample evidence that the US corporate sector is in the late phase of the credit cycle. Examples include the high level of corporate debt, companies’ emphasis on equity-friendly measures such as mergers, acquisitions and stock buybacks rather than healthy balance sheets, and the deterioration in the terms of new bond issues, which increasingly favor the issuer at the expense of bondholder protections.
We view the late stage of the credit cycle as the least attractive time to hold corporate bonds: defaults tend to increase and the corporate sector as a whole tends to experience higher volatility and lower returns relative to government bonds.
In the current environment, the case for holding corporate credit risk in the late cycle is more complex. Fundamentals are clearly deteriorating and we would normally expect spreads to widen at this stage of the cycle. However, investor demand for yield continues to provide a significant tailwind for corporate bonds. We think this demand is being driven by the extraordinarily low yields on government bonds and the expansion of central bank bond purchase programs in the UK, Europe and Japan.
With this in mind, we consider a range of pros and cons for holding credit risk, in addition to where we think we are in the cycle. When we weigh those pros and cons relative to valuations in the market, we are increasingly cautious but still somewhat constructive on high yield at current spread levels.
For the rest of 2016, we think the most likely scenario is that the high yield market moves sideways. Near-term, the Italian constitutional referendum and the US presidential election could lead to higher volatility. However, compared to earlier this year, we assign marginally lower probability to the risk that political events will create a major turning point given central banks' ongoing commitment to stimulate markets and the relatively short-term impact of the UK's European Union referendum.
Over the longer-term, if we are wrong about credit being in the late cycle, spreads could continue to tighten for some time, as we saw in 1986 and 2011 (Exhibit 2, top chart). However, we think the more likely scenario is that the policy environment has created a temporary rally in a longer-term trend of wider spreads and underperformance, similar to the rallies that occurred in the 1997-2002 period (Exhibit 2, bottom chart). If that is the case, we believe now is not the time to reach for yield in the corporate bond sector.
Source: Morgan Stanley, the Citigroup Index. “BBB” represents the lowest investment-grade credit rating. Left chart plots spread data for 3/85 to 3/89, 5/10 to 5/14 and 7/14 to 8/16. Right chart plots spread data for 7/97 to 11/02 and 7/14 to 8/16. Time periods chosen are representative past examples of late cycle and mid cycle spread behavior.
Looking across fixed income sectors, we think the securitized sector offers attractive alternatives to corporate bonds as a source of yield, with less exposure to the corporate credit cycle. Within the high yield market, we see more value in the higher-quality part of the market and we are more cautious about the lowest-quality (CCC-rated) segment of the market. We also see value in industries we expect to benefit from continued US growth, including building materials, commercial services and technology.