A Tale Of Two Markets: Opportunities And Challenges In High Yield

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By Tom O'Reilly, CFA, Head of Non-Investment Grade Fixed Income; Daniel Doyle, CFA, Senior Portfolio Manager, Non-Investment Grade Fixed Income; and Patrick Flynn, CFA, Senior Portfolio Manager, Non-Investment Grade Fixed Income

Portfolio Managers Tom O'Reilly, Dan Doyle and Patrick Flynn share their outlook for the high-yield credit market and where they see opportunity over the next 18 months.

Tom: When you look at the high-yield market today, we still think that the future is good for potential returns. Why do I say that? If you go back to 2008 and one of the worst recessions that we've had in our lifetimes, the high-yield market defaulted out over 10 percent of the companies that were in the market - those business models that could not operate within a very difficult economic time. Since 2008 and 2009, the majority of the companies that are in the market today have already been tested on a very severe downside.

They've already survived 2008. So we think that fundamentally, when you look at the high-yield market and the underlying companies that are in the market, defaults away from commodities are going to be very low for the foreseeable future.

Patrick: One of the questions we get a lot in high yield is: how do we deal with the volatility in the market related to energy, metals, and other commodities? Certainly for the last year, there has been quite a lot of price activity in basic materials. As a result, there have been a number of high-yield companies that have had problems.

The way we deal with it is how we deal with every other credit issue that comes into our market, which is really our credit best practices and our disciplined credit approach. We only invest in commodities companies that we believe can live through a downcycle, whether it's because of their cost position or the amount of debt they have or the types of resources that they have in the company. We want to be sure that they're going to be able to pay their debt even in a prolonged downturn.

Dan: You can think of the high-yield market as two separate markets: commodities that have been under severe pressure under the past couple of years and the non-commodity part of the high-yield market that's been much more stable. We expect that non-commodity part of the market, or 80 percent of the high-yield market, to continue to have a relatively low default experience over the next few years. As opposed to that, we see an increasing default experience in the commodities space in 2016 and 2017.

The low interest rate environment we have had over the past few years is likely to continue going forward. When that interest rate does begin to rise, I don't think it'll be a surprise to investors. I think it's likely to rise slowly and not shock the market. But again, when that rate begins to rise, it generally means that US GDP or the US economy is beginning to recover more. And that is significantly positive for high-yield bonds.

Tom: We're always looking for secular changes in businesses. You know, you saw that in the paper industry. You saw it certainly within certain retailers like video retailers. But it's not just about secular changes within industries. It's also regulatory changes.

For example, the healthcare industry relies on reimbursement rates for the government. If those reimbursement rates change significantly, that could also change the credit profile of a company to the point where it might default.

For us, it's about any kind of signal within an industry that might be changing that could have a significant impact on the underlying credit.

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