Weathering The Market Volatility Storm; Clear Skies On The Horizon For High Yield
By Darrin Smith, Portfolio Manager, Principal Global Fixed Income Since the beginning of June, high yield spreads have widened by over 150 basis points (bps). The energy sector is trading above 1,000 bps, blowing past the December wides. And although the rest of the high yield sectors have held up, no sector has been immune to market volatility. In light of recent market events, a good question to ask is: “Is this the beginning of a recession or just growth scares caused by a slow-down in China?” Our high yield team believes the latter, but in the current market environment, it’s not easy. But keep in mind, we’ve seen the growth scare before (remember the double-dip scare from 2011). High yield has traded off hard from May to August in recent years, so this mid-year volatility is nothing new. We expect volatility to continue into the first couple of weeks of September at the very least, but as current spreads approach 600 bps, we believe risk/reward is fairly attractive right now. Still, another good question is: “What role do the poor performing energy and metal sectors play in high yield’s ability to weather the volatility storm?” We understand the pain that’s been inflicted and will continue to be inflicted on the energy and metals sectors, but these sectors only represent 8.5% and 4.8%, respectively, of the total high yield index. We hear all the time about the headwinds in high yield being driven by the decline in energy prices, but this has mostly been an issue of oil supply rather than oil demand. For the rest of the sectors in high yield, $2 per gallon gasoline could provide a meaningful tailwind. Additionally, the underlying fundamentals of companies that are not in these sectors continue to be very robust (making the assumption this is just a growth scare and not the beginning of a recession). So where does this leave investors who are staring at a volatile market? Is there an end in sight? Our high yield team believes there will be volatility for at least another month given traditional poor performance of high yield during the late August/September timeframe and as we await further clarity surrounding the September Fed meeting. However, we do see spreads tightening from current levels heading into year end and into the first part of 2016. So, what are we doing in the interim in light of this forecast? Maintaining a Sector Focus: Our favorite sectors right now are finance, life insurance, leisure, automotive, and pharmaceuticals. For the most part, these sectors will benefit from reduced gasoline prices and are more tied to the consumer. The near-term default potential for these sectors is also very low. Establishing a Region Focus: We think European high yield offers value, as this segment has limited exposure to energy names and commodity weakness actually provides tailwinds for economic growth in the European high yield region. Examining our Sector Allocation: We are currently underweight energy. Nevertheless, we still have names that have been negatively impacted by the large sell-off in energy prices. We have not started buying back into the sector, but we are focusing on basins, balance sheets, and forward hedges (check out a previous post on this topic) that are in place for each company that we own. When we step back in, we will be adding to the higher-quality issues that have these positive characteristics. Evaluating our Credit-Rating Allocation: We are still overweight single-B’s, and we feel that our CCC’s have been rated incorrectly by rating agencies and should actually be rated higher. We will not call a bottom right now, but since the end of the financial crisis, the high yield market sells off during this timeframe every year. If our view is correct, and this is just a temporary growth scare, we believe the risk/reward is attractive right now, as long as you can withstand volatility over the next few weeks.