Outlook for High Yield

For Marketing Purposes For professional / qualified / institutional clients and investors Outlook for High Yield 219 Carry 5 UBS Asset Management By: Craig Ellinger, Head of Fixed Income, North America and Anaïs Brunner, Fixed Income Specialist The paper examines the market conditions in 218 and provides insight into the developed market high yield 219 total return forecasts.

High Yield market outlook Before we explain how the high yield bond sector should perform in the coming year, we should take a quick look back to remember what drove performance in 218. In short, total returns were slightly negative in the two largest segments of the global high yield market. High yield bond prices fell due to a rise in interest rates and credit spreads despite the continued low default environment. With the Fed rising interest rates on four occasions in 218 the interest rate sensitive segments of the high yield market began to suffer. By mid-218, coupon income was unable to offset the negative price return associated with rising interest rates and total returns approached zero. During the second half of the year, the market became spooked by the potential of failed Brexit negotiations, Italy s acrimonious budget negotiations with the European Commission, and a retaliatory tariff battle between the US and China. The market also became less confident in the Fed s ability to acknowledge the negative effects of geopolitical events on global growth, and fearful that it would continue to tighten monetary policy in 219. All of this uncertainty resulted in higher credit spreads and an increased volatility. Towards the end of the year, the yield differential or spread between high yield bonds and government bonds had increased materially to approximately 5 basis points! With higher spreads, like higher interest rates, negatively impacting bond prices, the combined effect of both were just too much for the sector to handle, and by the end of 218 returns were slightly negative. The European high yield bond market suffered its first negative total return in seven years, closing down 3.6%. The US high yield bond market fared slightly better, but was still down by 2.3%. With the Fed rising interest rates on four occasions in 218 the interest rate sensitive segments of the high yield market began to suffer. Exhibit 1: High yield option adjusted spread 55 EUR High Yield US High Yield 5 45 4 35 3 25 31/12/17 31/3/18 3/6/18 3/9/18 31/12/18 Source: Bloomberbg, ICE BofA Merrill Lynch Indices, data as at 31 December 218. 2

Looking ahead to 219 After the quick refresher course, it is best that we put 218 behind us and look forward into 219. We expect geopolitical concerns and monetary policy changes to continue to plague the market and shape expectations for growth and bond yields. Headwinds to markets in 219 are expected to continue to include the impact of a trade war between the US and China, the inability of UK officials to effectively solve the Brexit conundrum, and mostly about the Fed turning a blind eye to the warning signs of a partially inverted US yield curve. As a result, we believe the pulse for global economic growth will decelerate near trend and inflation pressure will remain tepid. Thus, we do not expect any material upward pressure on interest rates. Laying the foundation on interest rates helps us determine how to position our fixed income portfolios most notably in high yield. Our base case forecast calls for developed market government bond yields to level out at about 3 to 5 basis points higher across the curve. This may result in some negative performance, so we are inclined to own bonds that are shorter in duration or less sensitive to changes in interest rates. With an economic foundation and interest rate forecast in place, we can focus on the most critical component of high yield returns, the spread above government bond yields. This spread is often referred to as the additional carry (or income) an investor receives versus government bonds with a similar maturity or duration. This carry is intended to compensate investors for the additional risks that come with high yield investing, particularly credit risk. Thus, it makes sense that high yield bond spreads change as the market s perception of credit risk changes. We mentioned earlier that spreads materially increased in 218 (actually by about 2 basis points). In our minds, this was necessary to compensate investors for dubious trends in credit fundamentals. Our high yield analyst team has...we are inclined to own bonds that are shorter in duration or less sensitive to changes in interest rates. Exhibit 2: Historical total and excess returns (%) 8% Total Return - European High Yield HEC Excess Return - European High Yield HEC Total Return - US High Yield JUC Excess Return - US High Yield JUC 6 4 2-2 -4-6 2 21 22 23 24 25 26 27 28 29 21 211 212 213 214 215 216 217 218 Source: ICE Bank of America Merrill Lynch Indices, as at 31 December 218. Note: Past performance is no guarantee of future results. 3

Our base case forecast calls for spreads to close the year near 5 basis points above government bond yields. noticed deterioration in credit metrics of many European and US high yield borrowers. They specifically cite margin pressure from higher raw material costs, logistical costs, labor costs, and funding costs. As margins contract, earnings and cash flow pressure materializes and leverage increases. As leverage increases, investors should demand higher spreads. While fundamental pressure on high yield credit is evident to us, we do not yet see enough evidence to warrant a significant upward change in spreads from here. Conversely, there are few positive catalysts on the horizon to warrant a downward change in spreads as well. Our base case forecast calls for spreads to close the year near 5 basis points above government bond yields. Exhibit 3: Fundamentals: Leverage High yield net leverage (net debt over EBITDA) 5. EUR HY Net Leverage US HY Net Leverage 4.5 4. Net leverage 3.5 3. 2.5 2. 1.5 1999 21 23 25 27 29 211 213 215 217 Source: Morgan Stanley data as per end of June 218. 4

To round out our projection for high yield returns we must establish a view on defaults. This is essential because any unexpected defaulted bonds in the high yield universe will eat into our projected returns. To do this, our high yield credit analyst team reviews each bond in our underlying high yield bond indices to form a comprehensive bottom-up estimate of defaults and distressed exchanges by industry. In Europe, we forecast defaults of 1.8% and in the US, 2.5%. To put our forecasts in context, the long-run average annual default rate for high yield is approximately 4.4%. We do not stop there. The next step is to include a recovery assumption in order to determine a loss for each defaulted bond based on its current market price. Our analysis suggests the market will experience a only a small negative price impact from defaults between.5% and.7%, which is also fairly low by historical standards. In Europe, we forecast defaults of 1.8% and in the US, 2.5%. Exhibit 4: UBS AM High Yield bond default expectations: 219 US High Yield defaults expected to be 2.5% EUR High Yield defaults expected to be 1.8% $15, 2.5% 2,4 1.8% Defaults (USD m) 12, 9, 6, 3, 2. 1.5 1..5 Contribution to expected defaults Defaults (EUR m) 2,1 1,8 1,5 1,2 9 6 3 1.5 1.2.9.6.3 Contribution to expected defaults Energy Retail Basic Industry Services Consumer Goods Healthcare Transportation Capital Goods Technology & Electronics. Banking Basic Industry Capital Goods Retail Transportation Energy. Source: UBS Asset Management, data as at December 218. Note: This does not constitute a guarantee by UBS AG, Asset Management. Bar shows USD/EUR amount of total defaults based on original face value. Triangle shows contribution to total expected default percentage. 5

Since we do not see a material uptick in default rates in 219, we believe the end of the credit cycle is at least a year away. However, defaults peak well after the credit cycle ends, so it is better to look toward our forward looking spread estimates to gauge our opinion of the credit cycle. The repricing of credit through higher spreads suggests that lending conditions are tighter. This is a healthy reaction by the market. At the new higher spread levels, the demand for high yield should be strong enough to absorb any new supply. This should limit the probability of significantly wider spreads in 219. This is important because when developed market high yield spreads begin a sustained march toward 8 basis points or more, the end of the credit cycle is probably just around the corner. The cycle will turn eventually, just not this year. We think that as global economic growth slows near trend, so will the expansion phase of the credit cycle. The cycle will turn eventually, just not this year. Investors should not be overly concerned about it. The two major developed high yield market segments are fairly valued, so stay engaged for the income benefits and carry 5! Exhibit 5: UBS AM High Yield bond return forecasts: 219 Total return forecasts Excess return forecasts 8% 6 6.6% 7.2% 8% 6 6.5% 6.4% 4 4 4.3% 2.8% 2 US High Yield - Total Return EUR High Yield - Total Return Short Duration High Yield - Total Return US High Yield - Excess Return EUR High Yield - Excess Return Short Duration High Yield - Excess Return Source: UBS Asset Management, data as at December 218. Our return estimates are based on a forecasted trading range of spreads, terminal spread level at year-end and government bond yield levels. We also incorporate loss expectations generated from the difference between the consensus default rate forecast and our own default rate forecast. We assume that spreads are negatively correlated with government bond yields. This does not constitute a guarantee by UBS AG, Asset Management. Past performance of investments is not necessarily an indicator of future results. 6

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