INCOME
EATON VANCE
Looking beyond traditional sources of yield
FEBRUARY 2017 TIMELY THINKING
High-yield bond outlook: Cautious optimism for 2017 following banner year Michael Weilheimer, CFA Director High-Yield Investments Jeff Mueller Portfolio Manager High-Yield Investments
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drove high-yield bond returns to 17.5% in 2016. ■■
Kelley Baccei Portfolio Manager High-Yield Investments Steve Concannon, CFA Portfolio Manager High-Yield Investments
A rebound in the energy and metals and mining sectors
Fundamentals of high-yield issuers improved in 2016, while supply and demand were also supportive of tighter spreads.
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Strength in commodities and overall improvement in earnings have put downward pressure on defaults – a
Will Reardon Institutional Portfolio Manager High-Yield Investments
trend we expect to continue in 2017. ■■
We are cautiously optimistic about the prospects for 2017, but see nothing close to the exceptional returns of 2016.
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FEBRUARY 2017 TIMELY THINKING
High-yield bonds led fixed-income sectors in 2016, in an impressive rebound from two subpar years. In this Q&A, the Eaton Vance high-yield portfolio team discusses their perspective on the market, including the outlook for 2017. What factors drove the outsized return of high yield in 2016? The riskier sectors of the market – energy, and metals and mining – had been beaten down in 2015, with spreads reaching their widest in February 2016. As signs of economic growth firmed last year, the rebound was sharp, with energy, and metals and mining rising 38% and 43% respectively. Those sectors contributed 6.7 percentage points of the 17.5% return on the BofA/Merrill Lynch U.S. High-Yield Index (the Index).1
2017 HIGH-YIELD OUTLOOK • 2
The asset class remained under pressure for much of November, but inflows started to pick up toward the end of the month, as investors anticipated that the new administration would push through tax reform, deregulation and fiscal stimulus to boost growth. In late November, OPEC agreed to production cuts, which helped to stabilize oil prices, benefitting high-yield issuers in the energy sector. In the beginning of December, the U.S. Federal Reserve’s widely anticipated decision to raise rates had almost no impact on high-yield bonds – it was well anticipated and priced into the market.
Having said that, it was a banner year for the overall market, thanks to improved U.S. economic data, strength in the labor market and a supportive commodity backdrop. The average high-yield spread in the Index tightened by 440 basis points between February and year-end 2016.
Against this backdrop, the technicals were supportive. Overall demand for high yield was firm, particularly during the second half of the quarter, with a $7.4 billion inflow into high-yield funds in December alone. From what we were seeing, institutional demand seemed to be consistently firm across the quarter. New issuance lightened in the fourth quarter, continuing a trend in place for the year. In 2016, new issuance amounted to $286 billion, about 2% less than 2015.
It seems like the market stumbled a bit in the fourth quarter.
Was the economy’s improving outlook in 2016 reflected in high-yield credit quality and fundamentals?
That is correct, but it still managed a return of 2%. October started off on the strength of the factors just noted. But later in the month, uncertainty around the upcoming U.S. presidential election spurred outflows from higher-risk assets. Weakening oil prices and rising U.S. Treasury yields presented added headwinds.
Yes. The quality of new issuance improved, both in the fourth quarter and throughout the year. M&A activity, at the riskier end of the market, accounted for just 15% of new issuance in 2016, sharply down from almost 38% in 2015. Meanwhile, LBO activity was virtually nonexistent in our market. Bonds rated either split B, triple C or lower
The BofA/Merrill Lynch U.S. High-Yield Index is an unmanaged index of below-investment-grade U.S. corporate bonds. BofA Merrill Lynch™ indexes not for redistribution or other uses; provided “as is”, without warranties, and with no liability. Eaton Vance has prepared this report, BofAML does not endorse it, or guarantee, review, or endorse Eaton Vance’s products. 1
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Exhibit A
2017 HIGH-YIELD OUTLOOK • 3
New-issuance credit quality improved in 2016.
PERCENT OF TOTAL ISSUANCE
80 70 60 50 40 30 20 10 0
'06
'07
'08
'09
'10
Acquisition Finance
'11
'12
Lower Rated
'13
'14
'15
'16
Refinancing
Source: BofA/Merrill Lynch, December 1, 2016.
accounted for only 11%, down from about 16% in 2015 (Exhibit A). At the same time, refinancings are up to 58% of issuances, versus 43% in 2015. Issuers are locking in rates that are still very low by historical standards and pushing out maturities. New issues are the bellwether when excessive risk seeps into the market, but we didn’t see that happening in 2016.
Exhibit B
Fundamentals improved modestly for the high-yield market, as well. The asset class had positive revenue growth year over year in the third quarter for the first time in several quarters, both including and excluding the energy sector. Also, it was the second consecutive quarter where we saw positive cash flow (EBITDA) growth year over year (Exhibit B), which helped reduce the average leverage ratio for
Cash flow strengthened in 2016.
150 120
YOY % CHANGE
90 60 30 0 -30 -60 -90
'09
'10
'11 HY EBITDA
Source: BofA/Merrill Lynch, December 1, 2016.
'12 HY Ex-Energy EBITDA
'13
'14 HY Ex-Energy Adj. EBITDA
'15
'16
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high-yield issuers for the first time since 2014. Interestcoverage ratios remain near all-time highs. The strength in commodities and overall improvement in earnings have put downward pressure on defaults. Monthly default volume peaked in the first half of 2016 and the trailing 12-month par-weighted default rate has been decreasing for the last several months, ending the year at about 3.3%. It’s important to keep in mind the vast majority of defaults in 2016 have come from issuers within the energy and metals and mining space. If you combine those
2017 HIGH-YIELD OUTLOOK • 4
revenue while lowering default rates for high-yield issuers. Technical factors should also be supportive. We anticipate that supply is likely to decline by 5% to 10%, while the continuing prospect of low global yields should keep demand firm. The asset class could, however, face a number of challenges. The Trump administration’s plans for protectionist trade policy could undermine growth. Trade wars can also feed inflation, which can pose a problem if it starts to accelerate. The timing and magnitude of further Fed rate increases are
sectors it’s roughly 20% of the market. If you exclude them and you look just at the other 80% of the market, the default rate is about 50 basis points (bps). We expect the default rates to continue trending down in 2017, within the range of 2% to 2.5%.
part of the picture, as well. We also recognize that energy, the single biggest sector in the high-yield universe, is not out of the woods yet. Further volatility in oil prices, for example, would likely have a negative impact on the energy sector and certainly on the market more broadly.
Could you share your thoughts for high yield in 2017?
Going forward, we will be looking for any signs of increased risk, including degradation of the fundamentals, a rise in LBOs, and/or lower-rated new issuance, or more new issuance to finance share buybacks and dividends; however, so far we have seen no cause for concern.
Looking at the balance of 2017, the safest prediction is that we will see nothing close to the exceptional returns of 2016. As of the beginning of the year, spreads are almost 150 bps below long-term average – high-yield valuations seem full. However, we are cautiously optimistic about the prospects for 2017. The Trump administration’s plans for tax reform, financial deregulation and fiscal stimulus should aid U.S. economic growth, which likely would benefit earnings and
Despite compressed spreads, we think that the high-yield sector – with appropriate due diligence – offers good relative value for 2017, and continues to provide an attractive strategic allocation in client portfolios.
FEBRUARY 2017 TIMELY THINKING
2017 HIGH-YIELD OUTLOOK • 5
About Risk An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer’s ability to make principal and interest payments. As interest rates rise, the value of certain income investments is likely to decline. An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Investments involving higher risk do not necessarily mean higher return potential. Diversification cannot ensure a profit or eliminate the risk of loss. Elements of this commentary include comparisons of different asset classes, each of which has distinct risk and return characteristics. Every investment carries risk, and principal values and performance will fluctuate with all asset classes shown, sometimes substantially. Asset classes shown are not insured by the FDIC and are not deposits or other obligations of, or guaranteed by, any depository institution. All asset classes shown are subject to risks, including possible loss of principal invested. The principal risks involved with investing in the asset classes shown are interest-rate risk, credit risk and liquidity risk, with each asset class shown offering a distinct combination of these risks. Generally, considered along a spectrum of risk and return potential, U.S. Treasury securities (which are guaranteed as to the payment of principal and interest by the U.S. government) offer lower credit risk, higher levels of liquidity, higher interest-rate risk and lower return potential, whereas asset classes such as high-yield corporate bonds and emergingmarket bonds offer higher credit risk, lower levels of liquidity, lower interest-rate risk and higher return potential. Other asset classes shown, such as municipal and investment-grade bonds, carry different levels of each of these risk and return characteristics, and as a result generally fall varying degrees along the risk/return spectrum. Costs and expenses associated with investing in asset classes shown will vary, sometimes substantially, depending upon specific investment vehicles chosen. No investment in the asset classes shown is insured or guaranteed, unless explicitly stated for a specific investment vehicle. Interest income earned on asset classes shown is subject to ordinary federal, state and local income taxes, excepting U.S. Treasury securities (exempt from state and local income taxes) and municipal securities (exempt from federal income taxes, with certain securities exempt from federal, state and local income taxes). In addition, federal and/or state capital gains taxes may apply to investments that are sold at a profit. Eaton Vance does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision.
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