Last week's Brexit vote surprised the market which was assuming "Bremain," causing the S&P 500 (NYSEARCA:SPY) to decline by 3.6%, and other markets to be jolted as well. Oil declined by 5%, gold surged 4.4% and importantly, the 10-year U.S. Treasury rate declined by 9% from 1.74% to 1.58%, the lowest rate since 2012.
We believe that the impact on the U.S. economy will be minimal and the market reaction seems overblown. Everything we read about the decision seems to hinge on one word: uncertainty. No one quite knows how Brexit will affect Europe and the world, although the consensus seems to be that it is certainly negative for the British economy. How will it impact us here? No one seems to know.
Janet Yellen told a Senate hearing last week, responding to a question if a Brexit would push the U.S. into recession, that: "I don't think that's the most likely case, but we just don't really know what will happen, and we'll have to watch very carefully." This line is another way of saying "I have no clue." A smart comment came from Glenn Hubbard, a top economic official to President George W. Bush and now dean of the Columbia Business School (my Alma Mater): "I think a lot of the market reaction is less about the financial impact and more about populism and what it means for the liberal economic order." Again, no articulation of any actual impact on the U.S. economy or corporate profits.
Let's look at facts. Britain is only the 7th largest trading partner with the U.S., with $56 billion of exports, or only 0.3% of GDP -- almost a rounding error. Trade with China is many multiples larger -- recent slowdown fears in China are far more impactful than Brexit. While there may be other factors that could cause a U.S. recession, Brexit does not appear to be one of them.
How does Brexit impact high yield bonds, an asset class that our investment advisory practice specializes in and follows closely on a daily basis? (See recent articles on high yield bonds here and here) In our view Brexit is either a non-event and possibly a positive. While in the short run possible continued stock market turmoil will surely negatively impact the prices of high yield bonds, for the buy-and-hold investor (especially for those who hold individual bonds, the best way to invest in this asset class in our opinion) the outlook if fine.
Most importantly, the Brexit appears to have delayed interest rate hikes in the U.S. All else being equal, rate hikes are a negative for high yield bonds. The decline in the 10-year treasury to 1.58% and what appears to be "lower for longer" interest rates simply means better relative returns for bond investors. High yield bonds yields have come down in the last couple of months as the asset class has recovered from the swoon earlier in 2016, driving down yields. These yields now look more attractive.
From a credit perspective, we see little impact from Brexit. We note that the vast majority of U.S. high yield issuers are mainly domestically focused companies, not large multinationals that are more impacted by trade and currency rates. A rising dollar may hurt U.S. exports, but this is mainly an issue for larger multinationals, not the typical high yield bond issuer. Let's take a look at the top-10 companies in the iShares iBoxx High Yield Corporate Bond ETF (NYSEARCA:HYG) as a proxy for the key issues in the index:
1. HCA -- A U.S. only hospital company, zero impact from Brexit
2. T-Mobile -- A U.S. only wireless carrier, zero impact
3. CCO Holdings (Charter Communications) -- A U.S. only cable/telecom company, zero impact
4. Frontier Communications -- A U.S. only telecom company, zero impact
5. Ally Financial -- A U.S. focused finance company, close to zero if not zero impact
6. Tenet Healthcare -- Acute care hospitals in the U.S., zero impact
7. Dish DBS -- A U.S. only satellite/video telecom company, zero impact
8. Navient Corp -- A U.S. only student loan company, close to zero if not zero impact
10. First Data Corp -- Point-of-sale processing, 85% of business for U.S. merchants, minimal impact
Number 9 is Numericable SFR, the largest cable/Internet company in France. While a totally European company we don't see exactly how a Brexit will cause people in France to cancel their cable and Internet services. Note that we are not recommending any of these bond issuers, in fact, we would avoid several of these bonds and generally do not favor the high yield bond index fund (again, we prefer selecting our own bonds based on our own credit analysis). The point was to illustrate that a Brexit will have minimal to no impact on the actual credit quality of these bonds. We can continue this analysis down the index (as well as the other key ETF, SPDR Barclays High Yield Bond EFT, Ticker: JNK) to show how the vast majority of U.S. high yield issuers are not global companies.
There are other risks to high yield bonds and all investments of course, but all else being equal, and simply looking at the effects of Brexit alone, we do not see any material impact on high yield bonds. While market turmoil may very well continue, this volatility alone in reaction to "uncertainty" and a "changing world" is not affecting our long-term view of this asset class. We very much welcome lower interest rates for longer, which seems to me the most tangible effect on the U.S. economy (currency exchange rates may also have a material impact), and plan to closely watch the high yield bond market for bargains that could emerge that we can add to our buy-and-hold to maturity portfolios.
Please consider Downtown Investment Advisory's recently launched subscription service through Seeking Alpha, The High Yield Bond Investor. The newsletter offers deep analysis of three recommendations per month, focused on yields in the 6%-8% range for the buy-and-hold investor, as well as regular exclusive insights on this asset class. We seek to uncover undervalued and "off the radar" opportunities. Please see our profile page for important disclaimers.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.