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.”
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.”