Tipping the Scale Toward High Yield Bonds

Global CIO Commentary by Scott Minerd

After its September Federal Open Market Committee Meeting, the U.S. Federal Reserve made it clear that any reduction in its program of quantitative easing (QE) is unlikely in the near-term. Since then, Washington battles over the budget and the debt ceiling have confirmed our view that QE will continue until at least the first quarter of 2014. Washington gridlock will affect near-term growth and should be good for bonds because lower fourth quarter GDP leaves room for interest rates to fall. Lower interest rates have already reignited the search for yield and are changing the dynamics in the below-investment grade market. Mutual fund investors, no longer faced with the prospect of rising rates, may start thinking about leaving floating-rate funds in search of higher returns from high yield bonds. These developments are positive for below-investment-grade bonds and make this a good time to consider increasing exposure where appropriate. So far this year, flows into bank loans have been consistently positive, as has performance. However, our latest High Yield and Bank Loan Outlook report reveals that high yield bond fund flows have been volatile, and performance has been uneven. Now that the risk of a near-term increase in interest rates has faded, we expect to see more stability in high-yield flows and more volatility in bank loans as mutual fund investors reposition to search for yield rather than protecting themselves from rising rates. Despite the volatility experienced in the third quarter, our research shows that default rates for below-investment-grade bonds typically remain low for some time following periods of monetary accommodation. The Fed has indicated interest rates will remain near zero at least until mid-2015, and we expect rates to stay low even longer. The take-away for investors in the below-investment grade market is that the fourth quarter outlook appears positive, and more positive for high yield bonds than bank loans.

Default Rate Trends Following Periods of Monetary Accommodation

Speculation on the future of quantitative easing may keep volatility elevated during the fourth quarter, but fundamentals in the corporate credit market remain solid. With borrowers having locked in lower borrowing costs over the next few years and short-term rates expected to remain low at least until mid-2015, concerns that high-yield borrowers may not be able to meet their obligations are mostly muted for now. Data since 1986 shows that periods of monetary accommodation have typically been followed by prolonged periods of low default rates.

FEDERAL FUNDS TARGET RATE VS. 2-YEAR FORWARD HIGH YIELD DEFAULT RATE

Source: Credit Suisse. Data as of September 30, 2013.

Economic Data Releases

Government Shutdown Leads to Light Data Week

• U.S. jobless claims inched up to 308,000 from 307,000 for the week ended September 28th.
• The ISM non-manufacturing index dropped to 54.4 in September from the prior month’s 58.6, a three-month low.
• The NFIB Small Business Optimism Index ticked down from 94.1 to 93.9 in September.
• Mortgage applications increased 1.3% for the week ended October 4th. Purchase applications were down for a second consecutive week.

Euro Zone Sales and Services Improve

• Gains in France and Italy helped push the euro zone services PMI to 52.2 in September from 50.7 in August.
• The volume of retail sales in the euro zone jumped 0.7% in August, driven by an increase in sales of car fuels and non-food products.
• Industrial production in Germany rose a better-than-expected 1.4% in August after a 1.1% drop in July.
• German exports rebounded 1.0% from a month earlier in August.
• U.K. industrial production unexpectedly fell in August, down 1.1%, which was the largest drop in a year.
• The RICS U.K. housing market survey showed 54% of respondents reported rising house prices in September, the highest proportion since 2002.
• China’s official non-manufacturing PMI rose to 55.4 in September, a six-month high. The HSBC services PMI fell slightly to 52.4.
• Japan’s economy watchers survey of current conditions rose to 52.8 in September after falling for five months.

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