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High yield expectations in 2018

The uncertainty surrounding the fixed-income market has continued to be discussed amongst market participants over the past months. As I have pointed out in previous writings, the debate is justifiable. The monetary tightening preposition should be of concern, however its effect, when considering all other factors, might not be as detrimental as investors think.

In 2017, the market effortlessly experienced a shift from recovery mode, following the 2015/2016 energy crisis, to a rally mode, in line with an economic recovery. High yield (HY) was not an exception and over the past months, credit has continued to register spread tightening. In my view the spread tightening was brought about by two factors; 1) a still relatively easy monetary policy; 2) improving credit fundamentals.

The latter wasn’t solely triggered by the improving economic recovery, but also by the opportunity given to HY issuers to re-finance at lower costs and to extend their debt maturity ladder. This naturally lessens the debt burden and gives companies the opportunity to adjust their working capital needs without the possible strains of upcoming maturities.

Moving into 2018, in my view, the big beta-driven moves we have seen in 2016 and early 2017 should be behind us. A clear factual example throughout mid-2017 was the continuous spread tightening in financial subordinated debt, which posted remarkable returns in 2017, following the experienced hemorrhage way back in 2016.

In fact, diligent investors, who managed to uncover value in the said financial subordinated debt, surely beefed up their performances remarkably. Few examples, which come to mind, are Banco Santander and Unicredit, the Italian Bank, which to the surprise of many has restructured its capital structure primarily through the write-off of non-performing loans, lower debt re-financing costs and a successful rights issue. An element of idiosyncratic risk was also being reflected in the widening spreads way back in 2016.

In 2018, we should continue to see modest amounts of yield tightening. I think the important point to put forward is that despite many might fear that the upcoming less accommodative stances by leading Central Banks will effect credit markets, investors should remember that the vast majority of returns in the high yield asset class accrue from the high levels of income or what we call in technical terms the carry trade.

Furthermore, another crucial point is the correlation preposition. Historically we have seen that HY has a negative correlation to government bonds, while it has a very high positive correlation (circa 0.88/0.9) to equity markets. This leads me to conclude that in the current benign market environment, HY should continue to perform relatively well and generate good levels of income. Undoubtedly, investors should not take excessive risks in terms of duration. If investors combine these factors, 2018 will still be an attractive year for bond investors. This is why way back I had opined that there will always be value in bond markets.

 

This article was issued by Jordan Portelli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.

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