Investors in high-yield bonds have enjoyed strong returns in the first half of the year, but the same performance is unlikely to be repeated in the second half, according to an asset manager who focuses on the asset class.
The Federal Reserve has been raising interest rates very gradually, with four quarter-point increases over the past 18 months, while other major central banks still are keeping rates at record lows.
"Obviously, the Fed is in play and that may limit some of the upside for high yield for the back half of the year," Scott Roberts, head of high-yield investments at Invesco, told Real Money in an interview. "The greatest risk for the markets is a misstep by the Fed, and that's why the Fed is so cautious."
The debate on whether interest rates will be raised more than one other time this year rages on. Some say another interest rate rise is all that the Fed will dare to do, while others cite increasing unease among policymakers about the rise in risk associated with the search for yield.
On Tuesday, June 20, Boston Fed President Eric Rosengren warned that low interest rates affect financial stability. "Reach-for-yield behavior can make financial intermediaries and the economy more risky," he said during a conference in the Netherlands.
Roberts said at this point in the economic cycle, this type of comment is not uncommon.
"I remember in 2007 when investors were reaching for yield trying to boost returns. That can work for a while, but when the credit cycle ends, when the business cycle ends, people realize they took on too much risk," he said.
The normal business cycle in the U.S. lasts 77 months, Roberts noted.
"We're beyond that, but the reason we're beyond that is central bank activity," he said.
Roberts said one reason not to worry too much about the end of this long business cycle is that defaults are low. Another reason is the lack of a rapid build-up in leverage.
"What's missing from our market is aggressive leveraged buyout (LBO) activity, and for the high-yield market that's a good thing," Roberts said.
In 2005-06, half the new issuance in the high-yield debt market was to support merger-and-acquisition activity by private equity to help finance takeovers. Today, that type of activity is less than 10% of new issuance, according to Roberts.
"Generally, when you have a spike in LBO activity in the high-yield market, you have a spike in defaults 18 months later. We don't have that going on today."
Companies' fundamentals are good, with earnings and revenues growing in the mid single digits, but confidence is important for this trend to continue, he said. Apart from the fear of the Fed making a mistake and raising interest rates too sharply, political risk is also increasing.
The reflation trade that many investors hoped would happen due to President Trump's promises to cut taxes, ramp up public investments and cut regulation is on hold as the president is sidetracked by investigations into the election campaign.
"This is dominating the headlines. Every time there's a new investigation, it puts that change in regulatory policy on hold ... I think [the reflation trade] is dead for this year. I think there are too many distractions for it to happen," Roberts said.
One area he is watching is the auto sector, where there are three worrying trends. The first is the slowdown in new-car sales volumes, albeit from record levels. The second is the softening of the used-car market, which affects not only car rental companies but also companies offering car leases and loans. Third, there are some defaults in car loans.
"If that problem gets big enough, it hints at potential problems in the wider economy," Roberts said. "It's a small part of the market, but it does bear monitoring to see if it spreads."
His fund prefers to remain in the space of high-yield debt from companies that are rated BB, as Roberts believes those in the CCC space are overvalued. The fund stays with a theme of investing with the strong U.S. consumer, but has cut exposure to retail. It invests in sectors such as food and beverage, consumer products, wireless technology and cable. The fund also cut exposure to energy and the drug sector.
