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The Opportunity in High Yield

Jeremy Hughes, CFA and Chris Langs, CFA

For the first month since August of 2013, the U.S. high yield bond market declined in July, with the BofA Merrill Lynch High Yield Index falling -1.32%. July also marked the worst month of performance for the asset class since June of 2013. However, during the first half of August, the high yield asset class has gained some of the ground lost last month, and we expect further stabilization as yields approach 6%.

In our view, the high yield selloff reflected sentiment and technical factors. Similar to last summer, July’s selloff was tied to investor concerns about when the Fed would begin raising short-term interest rates. While other risk assets experienced pressure later in the month, the high yield selloff began around the same time as Chair Yellen noted that valuations in the asset class “appear[ed] to be stretched.” While the long end of the Treasury curve remained resilient, the curve flattened as the short end continued to price in possible rate hikes in 2015.

In the wake of Fed comments, high yield exchange-traded funds (ETFs) experienced their largest outflows on record, which tested market liquidity. As ETFs sought to meet redemptions, more liquid BB and B rated credits were sold off, despite no deterioration in fundamentals.

As the impact of Fed rhetoric has waned, the asset class has begun to recoup ground. Overall, we believe high yield issuer fundamentals are still strong, with default rates expected to stay well below long-run averages for the next few years. Leverage has slowly crept higher but is still below the peak of the early 2000s, while interest coverage remains near its peak (see charts below). Despite more aggressive new issuance and looser covenants of late, we do not believe we are at an inflection point in the credit cycle. Even so, high yield investors should be prepared for periods of choppiness, with geopolitical risks likely causing market sentiment to swing between risk-on and risk-off.

Leverage Ratio: Well Below Peak

Source: BofA Merrill Lynch Global Research

Interest Coverage Ratio: Nearly at Peak

Source: BofA Merrill Lynch Global Research

Our view on interest rates is unchanged: We expect Fed tapering to end this fall and the Treasury market to continue to price in the first rate hike in 2015. Despite anticipated Fed tightening, we expect the long end of the Treasury curve to remain resilient and the yield curve to flatten. Weaker economic conditions in Europe will likely continue to push down interest rates in Europe and lead global investors to chase U.S. yields, as U.S. Treasurys remain more attractive on a relative basis.

Earlier this year, we had been concerned about high yield valuations, given investors’ determined quest for yield in a low interest-rate environment, and we believe these concerns proved valid. However, following the July selloff, valuations are beginning to look more attractive given the spread widening and the historical low correlation of the high yield asset class relative to Treasurys. Institutional investors who are well versed in the asset class are taking advantage of this recent selloff, as discussed in the The Wall Street Journal (“Large Investors Swoop In For Junk,” August 18). Expected low default rates should further support current valuations.

We see the most opportunity in mid quality (BB/B) issuers which have sold off by a similar amount to lower quality (CCC and below) issuers. With the recent back-up in the market, we believe the high yield asset class looks attractive relative to other fixed income alternatives over the next 12 months.

Related resources
High yield scenario analysis and commentary
Calamos High Yield Investment Process

Past performance is no guarantee of future results. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable.
The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. High yield bonds entail increased credit and liquidity risks.

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