Junk-Bond Investors Expect Below Average Return as Cycle ExtendsBy
High-yield return could be as high as 7%, less than equity
Investors like energy, selected retail and health care bonds
The U.S. credit market rally is almost a decade old and junk bond investors aren’t getting greedy. Most seem content forecasting below average returns for 2018, while some worry that high yield could soon turn sour.
Investors expect a total return of 2 to 7 percent for junk bonds next year. At the midpoint, it would be the worst year since 2015, less than the 9 percent average annual return for the 2007-2016 period.
A benign outlook assumes slim default rates, tame volatility, a slow and steady Federal Reserve and continued relative value compared to other credit markets. But not everyone’s buying it.
"What we’re seeing in this bull market environment is the over-valuation of certain asset classes, corporate bonds being one of them," said Jody Lurie, corporate credit analyst at Janney Montgomery Scott LLC. "We’re in a situation where we could be in for disappointment."
Others worry that markets have been too good for too long and if the cycle doesn’t turn in 2018, it won’t extend much beyond that.
Ken Monaghan, co-head of high yield at Amundi Pioneer, is concerned about rates on a 12-to-36 month horizon.
"There’s an enormous amount of money that has flowed into fixed income instruments of all sorts and varieties, including high-yield, because of this global search for income," said Monaghan, whose firm managed $53.7 billion of fixed income assets as of September. "What happens when rates start to rise in Europe? Do they start pulling their money back?"
Rising European rates could steer investors away from U.S. high-yield, which is "attracting capital because people have no place else to go," said Bloomberg Intelligence analyst Noel Hebert. Recovery from the financial crisis is getting "excessively long in the tooth," said Hebert, who projects a total return as low as 2 percent for next year.
Steady Fed Fuel
Junk bond bulls counter that the Fed’s cautious approach to tightening will keep the recovery chugging along for the foreseeable future. This should boost high yield.
"The most important change from the financial collapse -- and why everybody’s been so wrong -- is that the Federal Reserve has been a passive force in the marketplace," said Margaret Patel, a senior portfolio manager at Wells Capital Management who oversees $1.5 billion in assets. "The Fed is having a very mild effect on the real economy, which is a real positive."
Patel predicts a 4 to 6 percent total return for high-yield. "Equities will return substantially more -- 8 to 15 percent," said Patel.
Andrew Feltus, co-head of high yield at Amundi Pioneer, said he doesn’t anticipate any change when Jerome Powell takes over as Fed Chair from Janet Yellen.
"They clearly want to raise rates, but they are cognizant that growth is not exploding and inflation is well behaved, so they’re going to do that at a steady, measured pace," Feltus said. "I wouldn’t expect to see a large change in either the rhetoric or the actions of the Fed."
Energy Sector Allure
Bonds rated BB and higher could be attractive if the price of oil remains stable, Hebert said. Lower-rated communications companies will lose in the tax bill at the same time as they face other threats. "Secular headwinds for them are pretty severe," Hebert said. "They’re pricing in risk inappropriately."
Energy, one of the largest components of the high-yield market, will benefit from tax reform in the aggregate, although a provision governing interest deductions could hurt it, according to Bloomberg Intelligence.
Randall Parrish, head of credit at Voya Investment Management LLC, which managed $137 billion in fixed income assets as of September, is "reasonably constructive" on the energy sector, where he prefers exploration and production companies to offshore services. Monaghan also likes energy, particularly midstream companies.
In retail, some names have been able to beat very low expectations, and there is opportunity in the sector, although a "modestly rising tide may not lift all boats," said Parrish.
"Price discounts a lot of negative outcomes," said Monaghan, referring to retail. Monaghan also likes pharmaceutical and managed care companies in the health care sector.
For Patel, companies in the industrial, tech, materials and consumer discretionary sectors will benefit from stronger economic growth and lower tax rates.