By Davide Scigliuzzo
MIAMI/NEW YORK (IFR) – The tone was upbeat at an annual junk bond market conference in Miami this week, but some participants warned against aggressive risk-taking in an investment climate that has vastly improved over the past year.
Attendees of the three-day gathering organized by JP Morgan said credit spreads were likely to tighten further in 2017 helped partly by a possible fall in the default rate and a positive economic outlook under the Donald Trump administration.
The gathering – now in its 22nd year – was more optimistic than at last year's event, which took place shortly after a rout in commodity prices wreaked havoc across the asset class.
“It's like night and day,” said Mitchell Garfin, a portfolio manager at BlackRock. “The high-yield market performed quite well over the past 12 months and market sentiment remains strong.”
Company executives talked less about desperate plans to shore up balance sheets and avoid bankruptcy and more about expanding capacity and financing investments through new bond sales, investors told IFR on the sidelines of the conference.
High-yield bonds returned nearly 17.5% in 2016 and are already up by over 3% so far this year, according to data from Bank of America Merrill Lynch (NYSE:).
Buoyed by optimism over some of the policy proposals of the Trump administration, investors have piled US$ 6bn into the asset class since the US election in November, according to Lipper. The average US high-yield bond spread has tightened 141bp since then.
“The market is pricing in significant optimism and showing very little concern for potential risks, such as the upcoming French elections and the new administration's ability to deliver on tax and healthcare reform,” said Garfin.
TIGHTER FOR LONGER
Further supporting sentiment, issuance so far has been driven by higher quality junk-rated paper rather than some of the riskier trades of the past.
Junk bond sales to finance acquisitions and leveraged buyouts accounted for just 15% of total issuance in 2016, compared to 52% back in 2007 when some of the largest LBOs in history took place, according to JP Morgan data.
And issuance of aggressive structures such as payment-in-kind notes – which allow issuers to pay coupons with additional principal rather than cash – dropped from a peak of 12% in 2007 to near zero over the past two years.
“The best forward indicator of future defaults is the current underwriting environment,” said Patrick Flynn, a senior portfolio manager at Neuberger Berman, who expects the default rate to decline to just 2% this year from around 4% in 2016.
“We are not seeing a lot of aggressive deals and the market could continue to grind tighter.”
News that Japan's Softbank had agreed to merge its OneWeb satellite business with Intelsat – one of the most indebted companies at risk of default in the US market – fueled even more optimism among attendees when it hit the tape on Tuesday.
But if the recent spread tightening has allowed investors to pocket juicy returns, it has also reduced the opportunities to snap up new deals that pay a lucrative yield.
“When you look at individual credits, you really have to stretch to get an 8%-9% return,” said one high-yield portfolio manager. “There are no easy wins.”
And while Trump's policy proposals occupied much of the discussions, investors said the high level of uncertainty surrounding their implementation made it hard to make specific calls.
“It is much easier to model the impact of US$ 30 oil on a company's credit profile than trying to determine the implications of a border tax on an auto company based on the uncertainties surrounding that policy and timing,” said Justin Gerberaux, director of fixed-income credit research at T. Rowe Price.
Investors have been looking through the beaten up retail and healthcare sectors to spot companies with good fundamentals that were unfairly punished by the market, but said opportunities are still hard to come by.
Many, however, see the overall bullish tone as a sign of complacency in the market, and argue portfolio managers should refrain from reaching for yield in the current environment.
“The market is so strong maybe we carry at these levels for a long time but why chase performance now?,” said John McClain, a portfolio manager at Diamond Hill Capital Management.
“We are positioning to protect against a pullback because it could be meaningful at this point.”