A slower pace of growth and easier monetary policy has resulted in investor preference for fixed rather than floating rate assets, as evidenced by fund outflows from bank loan funds and fund inflows into high yield bond funds (Exhibit 1). Investor demand alongside policy support has helped US high yield deliver a robust positive total return in excess of 12% year-to-date. However, concerns around downside growth risks—including trade protectionism and policy uncertainty—has resulted in outperformance of higher quality portions of the high yield market (Exhibit 2).
In our view, US high yield BB-rated bond valuations appear extended, with the spread differential over US BBB-rated investment grade bonds narrowing in recent months to hover around a ten-year low (Exhibit 3). We expect default activity to remain in check due to ongoing—albeit slowing—growth and accommodative policy and therefore maintain exposure to US high yield. In light of recent rating performance dispersion, we see value in adding exposure to the sector through resilient B-rated bonds and selective BB-rated bonds where valuations are less stretched. With respect to bank loans, despite year-to-date underperformance relative to high yield bonds, we do not consider valuations to be universally attractive. That said, we have identified some interesting opportunities to gain exposure to a particular issuer through loans rather than bonds due to valuation differences.
Source: Macrobond, GSAM, J.P.Morgan (fund flows) as of October 23, 2019, ICE BofAML indices (spreads) as of October 31, 2019.