Despite pockets of weakness, fundamentals remain solid overall, which should lend support to the U.S. and European high yield markets, as well as senior floating rate loans, in 2016.
In the U.S., Modest Growth and an Uptick in Defaults
Weakness in the energy and metals/mining sectors garnered the bulk of the attention in the high yield and senior floating rate loan markets in 2015. While this is likely to persist given slower demand from China, it's important to note that these two sectors represent less than 20% of the U.S. high yield market. Furthermore, we believe it masks the overall solid fundamentals in the other 80% of the market.
Looking ahead, we believe high yield valuations are generally compensating investors for default risk. Supporting this from a fundamental perspective should be continued GDP growth in the U.S. of perhaps around 2%. Within the high yield market, leverage remains moderate at 4.1 times debt to cash flow, while near-term bond/loan maturities have been significantly reduced through refinancing. It's also interesting to note that, over time, high yield bonds and senior floating rate loans have generally offered an attractive risk/return profile for their level of volatility.
High Yield Spreads Are Exaggerating Default Risk
Source: J.P. Morgan, S&P/LSTA, data as of November 30, 2015. Defaults based on par amounts. High yield spread to worst is represented by the J.P. Morgan Global High Yield Index. It is an estimate of the difference between the worst performing security and the best. Leveraged loans spread is represented by the discount margin (three-year life) of the S&P/LSTA Leveraged Loan Index.
That said, we think volatility could remain elevated. Defaults in the U.S. high yield market are currently2 estimated at around 1.5% for 2015 and could move up to 3% in 2016. An increase in commodity-related defaults could push this up further the following year and, by the end of 2017, defaults could be near their long-term average of 4.0%.
Another uncertainty is the Fed's transition to less accommodative monetary policy. While we anticipate several rate hikes in 2016, our view is that the Fed will take a gradual approach and move slower than many previously expected. It's important to point out that interest rates tend not to be the primary driver of high yield performance. Rather, GDP growth and defaults tend to be the key drivers, both of which we believe could lend support to high yield in 2016. Furthermore, historically an environment of gradual interest rate hikes has often been constructive for high yield bonds and senior floating rate loans, as it tends to mean the economy is on solid footing. In summary, we remain constructive on the overall high yield and senior floating rate loan markets, and believe that, excluding the commodity sectors, spreads could tighten over the next 12 months.
European High Yield Fundamentals Remain Solid
European high yield is in a "different place" from its U.S. counterpart, with fewer energy names and many issuers accustomed to a severe economic climate. Credit quality in Europe remains high, which in our view is likely to help keep defaults below their long-term average. Additional ECB monetary easing and the calming of 2014's concerns around sovereign debt should also be supportive. Moderate economic growth in the region may prompt management teams to be conservative, which should temper shareholder-friendly event risks in Europe-another positive for bond holders. From a market technicals perspective, we feel the continued low interest rate environment will likely drive solid demand and that the European high yield market can continue to expand rapidly. Against this backdrop, we believe there will be ample opportunities for security selection, particularly as intermittent volatility creates openings for alert buyers. In our view, European high yield markets could generate attractive total returns in 2016, primarily driven by income.
1Year-to-date through November 15, 2015.
2As of November 30, 2015.
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