Junk-Bond Bulls Ready to Run as Pimco, Goldman Say Rout Overdone

  • Problems in worst parts of market have `an exaggerated effect'
  • There's wide divergence between equities and high-yield debt

Junk bonds are poised for their first annual loss since 2008, and the list of companies headed for trouble is swelling. Yet to Mark Kiesel, who helps run one of the world’s biggest debt funds, the bonds haven’t been this attractive in a long time.

"Credit hasn’t looked this good in six years, and high-yield looks especially
attractive," said Kiesel, the chief investment officer for global credit at Pacific Investment Management Co.

He’s among a growing group of money managers and Wall Street analysts predicting that turmoil in the junk-bond market will give way to the same optimism that has buoyed the stock market the past two months. The U.S. economy is on a strong footing, he said. Junk bonds are yielding the most since 2011. And, outside the slumping commodities industry, the default rate is still half of its historical average.

It’s not a total embrace of the market. Defaults in the commodity industry are still forecast to accelerate. But investors are betting that won’t derail a U.S economy that saw a 211,000 increase in payrolls in November following a 298,000 gain in October that was bigger than previously estimated. Federal Reserve Chair Janet Yellen has signaled the growth is almost sufficient for higher borrowing costs and is preparing to raise interest rates as early as this month.

"The Fed lifting off will be less of a market event than people think," Kiesel said. "This economic expansion can continue even though the Fed is raising rates."

That’s because Mario Draghi’s easy-money policies in Europe are underpinning demand for higher yielding assets even as the Fed prepares to boost interest rates for the first time in a decade, according to Kiesel.

Kiesel finds debt of companies in the health-care, housing and consumer sectors attractive. He’s staying away from commodity-related credits.

While junk bonds have lost 0.8 percent this year, a closer look reveals that the declines are concentrated in the debt of energy companies, which has dropped 11 percent. Excluding those borrowers the rest of the junk debt market has gained about 1 percent, according Bloomberg Bond Index Data.

“The market is throwing the baby out with the bathwater," said James Sarni, a managing principal at investment manager Payden & Rygel, with $85 billion in assets under management. "There are a lot of fears in high-yield that are unfounded." 

But avoiding the worst performing sectors may not be enough to insulate investors, UBS AG credit strategist Matthew Mish warned in a research note to clients. He is concerned that the oil rout that drove junk-bond energy debt to its biggest loss since 2008 may spread to the rest of the speculative-grade market.

For every junk-bond issuer that had its rating boosted this year two have been downgraded, a ratio not seen since 2009, according to data compiled by Bloomberg.

And companies are increasingly defaulting on their debt. Swift Energy Co.’s failure to make an $8.9 million interest payment this week raised the global tally of default to 102 issuers, a figure last exceeded in 2009, according to Standard & Poor’s.

"Sector selection is particularly challenging," Mish wrote in the note, citing increased leverage. "Finding places to hide is not easy."

But Goldman Sachs counters that a 3.5 percent growth in the global economy in 2016 should underpin credit investments. While risk premiums for both investment-grade and high-yield debt are at levels that preceded recessions in 1990 and 2001, Goldman Sachs credit strategist Lotfi Karoui told clients that credit investors were being too pessimistic in their assessment.

Mutual funds that invest in junk debt saw inflows of $397.6 million in the week ended Dec. 2, snapping three weeks of outflows, according to Lipper.

That all adds up to a “buy" signal for junk bonds, says Scott Minerd, who oversees $240 billion as global chief investment officer at Guggenheim Partners.

High-yield bonds “are well positioned to enjoy a prosperous road ahead,” he wrote in a Nov. 23 note. “As investors realize the Fed is raising rates because the economy is strong, the fear of defaults diminishes and credit spreads tighten again.”

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