Despite the sharp turns in high yield markets over the past two quarters, companies ticked along without flinching—posting strong earnings over the course. David Mihalick, Barings’ Head of U.S. High Yield Investments, explains why.
We started this year with a strong rebound following a period of marked volatility in high yield markets during the fourth quarter of last year. Can you give us a sense for the drivers behind those events?
The last six months have undoubtedly been a roller coaster. If you look at risk assets, the S&P 500 was down about 14% in the fourth quarter, and then rebounded almost 14% in the first quarter. The high yield bond market was down about 5%, and came back over 7%. Loans were a similar story, down about 3% and up almost 4%.1
In our view, this was driven largely by technicals. If you look at how the fourth quarter unfolded, there were a lot of question marks around valuations at the beginning. Spreads were in the low 300s, there were negative headlines surrounding Brexit and the U.S.-China trade tensions, and there were concerns that the Fed would be too aggressive with raising rates. All of this led to softness in equity markets. We also started to see oil trade off, going down from around $70 per barrel to around $40. So, there was a cascading effect.
At the beginning of the fourth quarter, loans held up pretty well—so funds that owned them actually started selling them to meet redemptions. But as the quarter evolved and the Fed assumed a more dovish posture, there were outflows from loan funds as well—totaling around $15 billion in December alone.1 On the bond side, the market actually started to see inflows as we entered the first quarter of the year. Some of those flows were driven by the Fed’s change of posture, which motivated a lot of investors to move out of floating rate loans and into fixed rate bonds.
While investor sentiment was swinging from one extreme to the other, the companies in the high yield universe were quietly ticking along and, we know now, actually wrapping up a strong quarter from an earnings perspective. In fact, we track roughly 400 high yield issuers that also have public equities, and about 75-80% met or exceeded earnings expectations in the fourth quarter. While it’s difficult to pinpoint the exact cause of the performance mismatch between the companies and the markets, it’s relatively clear that fundamentals were not to blame for the volatility. In fact, high yield defaults today are still at historically low levels, around 1-2%. It was largely technicals—particularly retail outflows— that created the short-term instability, which drove asset prices lower and created a good buying opportunity for us at the end of 2018.
1. Sources: Bloomberg: S&P 500, BAML U.S. High Yield Index, Credit Suisse Inst’l Leveraged Loan Index. As of 31 March 2019.
2. Source: Lipper FMI. As of 31 March 2019.