Eoin Treacy's view -
HY total returns of 4.5% YTD have surpassed our YE target: In what has been a continuation of a strong 2016, total returns surpassed our Credit Strategists’ full year target of 3% by the end of the first quarter. We attribute much of the surprise to the US Treasury move lower, but also point out that current HY spreads of 390bp are ~50bp tighter YTD.
And US Treasury rates are … lower. We entered 2017 with the expectation that three rate hikes could help drive the 10yr UST 50bp higher, to 3.00% (GS Economics view). At mid-year, UST rates have instead declined 35bp, to 2.15% (see Exhibit 1) and our Economics team recently lowered their YE2017 forecast to 2.75% (from 3.00%). To be clear, the revised target still implies a 60bp move higher which could drive a headwind of 2.85% for the HY market (based on an average market duration of 4.76 years).
Spreads are tighter despite over $4.9bn of YTD HY outflows: With the rally in global risk assets, high yield market spreads have tightened ~50bp to 390bp, or inside the 20th percentile relative to the last 30 years. This spread move is even more surprising given it has unfolded in the face of $4.9bn of cumulative HY net outflows YTD. In fact, the HY market has experienced net cumulative outflows this late into the year only once in the last 10 years (see Exhibit 2).
Robust primary volumes continue: HY new issue activity surpassed $300bn in each of 2012, 2013, and 2014, and breached the $250bn mark for 2015. Despite dipping in 2016 (not surprising given the weak macro backdrop in 1Q2016) to $227bn, HY issuance appears poised to make a rebound this year with volumes trending up 6% yoy.
US policy is evolving and remains a key variable: The ramp in soft economic data (see Exhibit 3) suggests the outcome from last year’s election has positively impacted economic sentiment. However, hard economic data (like GDP), as measured by the GS Economics team has yet to inflect. For risk sentiment to remain elevated, we expect investors to be looking to the potential for the hard data to improve and growth to accelerate.
Disruption has been dangerous… what’s the next Rental/Retail/RLEC story? As the HY market has steadily marched higher, not all credits have participated. The market has been particularly unforgiving to stories where secular disruption has emerged. The rental, retail and RLEC sectors are prime examples here (see Exhibit 4) but we also have concerns over legacy software providers, the auto sector, the hospital facilities space and certain parts of media (see p. 4).
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The bond market has been the surprise outperformer this year particularly following the accelerated pullback following the election. The broader question is whether that is likely to continue if the Fed does indeed follow through on shrinking its balance sheet.
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