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Junk-Bond Buyers Are Content With Smaller 2018 Gains After Rally

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After seeing gains of about 7% this year, investors in the U.S. junk bond market aren’t getting greedy and are satisfied with predicting below average returns for 2018 amid concerns that an almost decade old credit market rally may soon fizzle out.

Total return forecasts for speculative-grade debt range from 2 to 7% next year. At the mid point, that would be the worst performance since 2015 and will fall short of the the 9% average annual gain for the 2007-2016 period.

Underpinning this benign outlook are a few assumptions: few defaults, low volatility and a Federal Reserve that’s not rushing to jack up interest rates. Not everyone shares this view.

“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 L.L.C.. “We’re in a situation where we could be in for disappointment.”

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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% 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% total return for high-yield. “Equities will return substantially more — 8 to 15%,” 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.

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