outlook : us and european HIGH YIELD bond IN 211 january 211 AT A GLANCE Expect mid-to-high single digit returns from high yield in 211 Company fundamentals are favourable and valuations are around fair Technical supports likely to remain as long as policy rates stay low Flow support for high yield in 21 was less acute than other asset classes Issuance likely to stay elevated Falls in high yield typically only occur when equities fall As we end 21 with another year of double digit returns behind us, investors are increasingly questioning their high yield investments. However, most investor concerns stem not from valuations, but rather technicals such as fund flows and the pace of the returns seen in recent years. We expect returns to shift down a gear in 211, but there are still good reasons not to lose faith in high yield just yet. Looking to 211, the fundamental backdrop for high yield is favourable. There has been a sharp fall in leverage over recent years (see chart below) and Fidelity s analyst upgrade-downgrade ratio has shifted back into positive territory. High Yield companies have used the primary market to refinance and extend the maturity of their debts, and with few bonds maturing in 211, the chances of liquidity induced defaults are low. Rating agency forecasts for defaults are also favourable, with Moodys forecasting global default rates below 2% in the latter half of 211 (and even as low as 1.2% for Europe). The key risk is the economic environment Sovereign contagion also threatens the market, but via its growth effect Expect income to drive returns, but economic risks are high High Yield Company Leverage is Low Net Leverage (Net Debt/LTM EBITDA, x) Leverage Ratio 4.4 4.2 4. 3.8 3.6 3.4 3.2 Average Leverage (3.7 x) 3. 1997 1999 21 23 25 27 29 Source: BofA Merrill Lynch Bond (November 21) VALUATIONS AROUND FAIR At a current spread of 5.98%, we would place the euro high yield market around fair value. Spreads are around historic average levels but are still well above the lows seen in previous cycles. If you believe favourable company fundamentals can support the market, then there is much room for spread compression. Compared against other asset classes, high yield looks reasonably valued. For example, high yield spreads are wide versus emerging market sovereign debt which is a market arguably more prone to idiosyncratic political risks (as well as greater interest rate sensitivity).
Spreads are still wide 3 25 2 15 1 5 99 1 2 3 4 5 6 7 8 9 1 Global Emerging Market Credit Global High Yield Global Emerging Market Sovereign Global Investment Grade Credit Source: Bloomberg, BofA Merrill Lynch Bond Indices (to 3/11/21) Low Yield But Still Wide Spread 3 25 2 % 15 1 5 High Yield Spread 5 Year Bund Yield 98 99 1 2 3 4 5 6 7 8 9 1 Source: Datastream, BofA Merrill Lynch Global High Yield European Issuers Constrained Index (to 1/12/21) On an absolute valuation basis, the yield on high yield bonds is less enticing. Yields are at the low end of the range experienced through history but the low yields reflect low risk-free (government) rates and our expectations are for government bond yields to stay relatively anchored in 211. TECHNICAL DRIVERS STILL FAVOURABLE - AS LONG AS POLICY RATES STAY LOW The flow support for high yield in recent years has helped underpin its strong performance. Many investors are now asking whether flows will reverse and derail the market in 211. Surprisingly, US high yield mutual fund flows (a proxy for global flows) in 21 pale in comparison to emerging market debt or leveraged loans. Therefore we don t view the flow issue as isolated to high yield. More important is the monetary policy outlook and as long as policy rates stay low globally, we believe the search for yield will continue, with high yield a natural beneficiary. In addition to the income chasers, we also believe there are ongoing structural shifts in demand for euro high yield bonds. Specifically, growth in strategic fixed income solutions, ageing populations and increasing demand from pension funds should continue to support growth and maturity of the European market.
Mutual Fund Flows YTD 21 Percentage Flows by Sector (US$bn figures on chart) EM Debt Loans Global Debt Commodities EM Equities HG Bonds All Taxable Debt HY Bonds Municipals US Equities Money Markets -$441 -$19 +$6 +$44 +$121 +$264 +$12 +$32 +$45 +$12 +$13-2 2 4 6 8 1 Pct of Assets Annual Percentage Flows Corp-High Yield 4 3 2 1-1 -2 1993 1995 1997 1999 21 23 25 27 29 Source: BofA Merrill Lynch Research (December 21) On the supply side, we expect another year of heavy issuance after a record year in the euro market in 21. Although large, 21 was not as big as we thought it could be and we were surprised by the extent of activity in the loan market (although more so in the US). Similar themes as 21 apply for next year lots of debut issuers coming to bond markets to diversify their funding sources from banks with the nature of issuance likely to be subdued due to the uncertain economic environment. The maturity profile isn t heavy next year (e.g. 6.4bn of euro high yield maturities in 211), although there are likely to be many calls of longer maturities. There is also a wall of senior secured loans maturing soon. With yields low in a historical context, companies will continue being proactive and using favourable market conditions to refinance. Quality may also get tested as the cycle progresses and we expect more issuance in lower rated areas. High Yield Bond Issuance 25, US Europe 2, $US Million 15, 1, 5, 1996 1998 2 22 24 26 28 21 Source: BofA Merrill Lynch Bond (December 21)
EXPECTING MID-TO-HIGH SINGLE DIGIT RETURNS IN 211 Combining favourable fundamentals, fair valuations and mixed technicals, we expect mid-to-high single digit returns from high yield in 211. However, volatility is likely to stay elevated as risk markets continue to grapple with the debt overhang facing developed economies, an uncertain monetary and fiscal policy environment and bifurcation of growth outcomes across the globe. Slow economic growth and moderate (but contained) inflation is our most likely scenario and we believe this is still a favourable environment for high yield returns. Most importantly, coupon income is expected to drive returns with coupons on the global high yield market at 8.2% per annum. With default expectations low, returns are likely to have strong tailwinds. Global High Yield Income and Price Returns 7 6 Price Return Income return Total Return 5 4 3 2 % 1-1 -2-3 -4 31/12/91 31/12/94 31/12/97 31/12/ 31/12/3 31/12/6 31/12/9 Source: Bloomberg, BofA Merrill Lynch Bond Global High Yield Index (to 3/11/21) Sovereign contagion is a risk So what are the risks? We believe the key risk is the fragile economic environment and threat of double dip in growth. This is not a risk isolated to high yield bonds and there are many ways growth risks could materialise. One is through ongoing sovereign stress. To date, high yield markets have been relatively immune to the sovereign stresses in peripheral Europe. Euro high yield underperformed its US counterpart in recent weeks, but this was driven by its greater share of subordinated bank debt - non-financials were little affected. As we head into 211, the de-coupling of sovereign from high yield spreads may get tested. Ultimately, rising sovereign risk (and spreads) could pressure risk assets due to its impact on growth across Europe, including core economies. Rising sovereign risk, steady high yield spreads there must be a limit 7 itraxx Crossover 25 6 2 5 4 3 SovX - Western Europe 15 1 2 1 5 Jan-1 Mar-1 May-1 Jul-1 Sep-1 Nov-1 Source: Bloomberg (to 16/12/21)
HIGH YIELD BONDS FALL ONLY WHEN EQUITIES FALL Investor flow reversal is another risk but we believe this would likely arise only if policy rates are increased materially and we see sustained periods of negative returns. Our base case for interest rates is low for longer and while we see chances of interest rate increases late in 211, we expect any increases to be modest due to the debt overhang facing developed economies these economies are now much more sensitive to rate rises. So what else could be the trigger for negative returns? Looking back at history (US data to the 8 s) reveals interesting insight - high yield bonds have never experienced a calendar year of negative return in the absence of a fall in equities. Therefore, being negative on high yield should mean also being negative on stocks. Companies are in good shape, default rates are low (and falling) and coupon income is attractive, so why shouldn t high yield continue delivering returns? We believe the majority of investor concerns about high yield stem simply from the performance seen to date the sheer pace of its recovery. We agree that it has been fast but so too has been the improvement in defaults. Indeed, this credit cycle has seen both the highest and fastest spikes in defaults, as well as the quickest improvement. Comparing default cycles across periods this cycle has seen the quickest improvement 16% May 89 Apr 97 Nov 7 (US) Nov 7 (Europe) US Baseline Forecas Europe Baseline Forecast 89-cycle recovery Apr 97-cycle recovery 14% 12% Default Rate 1% 8% 6% 4% 2% % 3.5% 2.% Months from the bottom in the default rate 5 1 15 2 25 3 35 4 45 5 55 6 65 7 75 8 85 9 95 1 15 11 115 Source: Moodys, 12-month issuer weighted default rates (November 21) Overall we are somewhat cautious on high yield for 211, but our reservations stretch much wider than this asset class. The economic risks are great, high yield bonds are susceptible to dips in growth, and with high yield valuations around fair, the scope for capital appreciation is now much lower than it was previously. The good news is that through market volatility, high yield investors continue to get paid coupons. This acts to cushion against capital weakness and dampen return volatility. So while investors should expect returns to shift down a gear in 211, coupon income should be firmly in the driving seat. FIL Limited, established in Bermuda, and its subsidiaries are commonly referred to as Fidelity or Fidelity International. Fidelity only gives information about its products and services. Any person considering an investment should seek independent advice on the suitability or otherwise of the particular investment. Investment involves risks. Past performance is not indicative of future performance. In general fluctuation in the performance of emerging markets is normally higher as it tends to be more volatile than other developed markets. Reference to companies mentioned within this document should not be construed as a recommendation to the investor to buy or sell the same, but is included for the purpose of illustration. Performance of the stock is not a representation of the Fund s performance. Please refer to the Fidelity Prospectus for Hong Kong Investors for further information including the risk factors. If investment returns are not denominated in HKD or USD, US/HK dollar based investors are exposed to exchange rate fluctuations. Fidelity, Fidelity International, and Fidelity International and Pyramid Logo are trademarks of FIL Limited.