The US's benchmark policy interest has undergone three rounds of cuts this year and is now in a range between 1.5% and 1.75%. It looks likely to remain low next year, and could fall even lower.
This theoretically makes US high-yield bonds favorable to investors. But that appeal depends in part on the economic environment, including the ongoing US-China trade war. Uncertainties remain even in the days leading to the deadline of the first-phase trade deal. The possiblity of more fallout on the US's economic health could cause more high yield defaults, and mean some investors prefer to invest in safer fixed income investments, like US Treasury bonds.
Given this enviroment, just how appealing are US high-yield bonds to investors? Should asset owners look to gradually increase their allocation in high-yield bonds next year, given their potential to offer better returns, and how should they balance this prospect against the risk of higher defaults as a result of geopolitical tension? Alternatively, are there other fixed income options offering decent yields that investors can consider instead?
As part of our Market Outlook 2020 series, AsianInvestor asked four investment professionals to share their views on this topic.
Their contributions have been edited for clarity and brevity.
David Cheng, head of Asia Pacific ex-Japan investment specialists
UBS Asset Management
We expect US high yield to deliver positive returns in 2020, but less than the strong performance seen in 2019. With yields still low globally, technical demand for US high yield will remain positive.
Fundamentally, we expect default rates to trend to historical average levels but recession is not in our base case scenario for 2020. However, certain segments of the market may be vulnerable to the outcome of the US/China trade negotiations.
While valuations are near the average over the past three years, concerns about the aging credit cycle, worries about the energy sector, weakness in CCC-rated bonds, and a saturated loan market may limit any further tightening in spreads.
The US presidential election later in the year could also be a source of volatility should the outcome be one less favorable to economic growth.
We expect 2020 to be largely a carry environment for US high yield with range-bound treasury interest rates but potentially periods of spread volatility. For more conservative investors, we would recommend a higher quality credit bias in short duration 'BB' and 'B'-rated high yield bonds. For multi-sector investors, we would advocate exposures to commercial mortgage-backed securities and Asian high yield bonds.
Martha Metcalf, head of global high yield
We enter 2020 with credit spreads at fairly lofty levels. We think a great deal of good news is priced into credit spreads currently, and room for material spread compression from here is limited as investors have been reaching out into the risk spectrum for the last several years. This has pushed spreads to near cycle tights, even in the context of a manufacturing recession, weak earnings in the US and trade policy volatility.
We believe that high yield supply will be somewhat flat next year. Factors driving higher levels of issuance, such as the percent of call constrained bonds that will be refinanced in 2020, are offset by factors driving lower levels of issuance, such as cooling merger and acquisition activity amid global uncertainty.
We expect demand for global credit to remain strong. While the market value of negative yielding debt has come off from recent peaks, it is still at historic levels. We think this will effectively push investors to take more risk as they reach for yield. We also believe that lower rates and central bank balance sheet expansion will compound this reach for yield, pushing investors into the higher yielding segments of global credit markets.
In terms of returns, we expect a more muted year than 2019, with returns driven primarily by coupon payments.
Vanessa Chan, fixed income investment director
After a remarkable set of total returns in high yield space across regions, investors face a critical crossroads where they have to be nimble to discover investment opportunities from a high dispersion of values.
While technical should remain broadly supportive in US high yield, valuations look relatively tight. We are yet to watch if the market will start repricing risks with a more prominent distress ratios and dispersion among credits and we see limited spread compression in BB space. We avoid companies that are trading at huge premia, yet we see interesting value in selected infrastructure, transportation and emerging market assets.
In contrast, we think valuations of Asian and China high yield remain attractive both on a historical and global basis and should continue to deliver a relatively high level of income in 2020. We believe that regional growth will be supported by fiscal and monetary packages from central banks while corporates fundamentals should remain largely stable.
However, investors have to be very selective as a divergence in performance is expected on the back of ongoing trade tension and lingering funding stress in some Chinese corporates.
Dhiraj Bajaj, portfolio manager and head of Asian credit
With the more accommodative US monetary policy since 2019 and a stable Federal rate outlook, the systematic risk for high yield has largely been taken out.
However, yields on an absolute level are nothing to shout about for US high yield, which offers only 3.8% for 'BB'-rated bonds and 5.7% for the overall high yield market.
Having said that, the flow of money from Europe and Japan in search from US dollar assets is significant and unprecedented, so the search for yield continues. For investors that can be a little more nimble, yield pick up and diversification opportunities lie aplenty in emerging market and Asian high yield credit markets.
In these emerging market and Asian markets, a lot of debt issuing corporates are domestically focused and benefit from long-term sector trends and are not necessarily impacted by the US-China trade fallout.