The US high yield bubble

Carpe Diem. The Romans were all about taking great risks to accomplish incredible objectives. Thanks to this philosophy, they conquered lands in the Mediterranean region, the Middle East, and northern Europe, ruling them for centuries. Nobody at the time imagined that the world could ever be any different, or that there could be other powers besides Rome, but history proved them wrong. As with all things, the Roman Empire eventually declined, contracted, and disappeared. It was just a matter of time… or timing.

Since the global financial crisis, there have been certain risky investments that have delivered such solid returns for so long that investors cannot imagine things ever changing. As the economic cycle ripens, however, and global politics continue their historic turn from democracy to populism, it is time to rethink these risky investments.

We are presently witness to a late economic cycle. Equity markets are near their all-time highs, interest rates are rising, and there is an overwhelming optimism among investors. Going by sentiment alone, it is as if markets do not expect this to ever end. 

The late economic cycle is being stretched further by President Trump’s policies’ boosting the American economy, and at this point many investors doubt whether a recession is going to follow at all. Ultimately, though, all things must decline, including this moment. The current, protracted cycle will be followed by a recession, and the only question is when.

Timing is a crucial element of investing. If you get it wrong, you are at best going to miss good opportunities and at worst, lose your portfolio. This is why it is important to think things through and understand when a market change is approaching in order to position yourself in the event of a downturn.

We believe that this is the time to do so. The financial market may be striving for another banner year pumped up by Trump’s expansionist policies, but eventually growth is going to slow down and the house of cards will quickly fall.

We believe that besides emerging markets, US high yield corporates are one of the biggest bubbles in the credit space. As shown on the chart below, US high yield spreads are trading at their lowest since the global financial crisis in 2008; the US junk bond space has been the best performer in the fixed income market since the beginning of this year. This comes down to a combination of investors’ confidence in the economy and the fact that high yield issuance is at its lowest level since 2010, but these are not good enough reasons to stay sitting on riskier assets while interest rates rise and the late-cycle US economy postponement of recession grows more improbable. 

Just as we have seen in EM, debt refinancing is the biggest risk facing weaker corporates at the moment.

Current default rates are still below 3% for high yield credits and this outlook shouldn’t change for either this year or the first half of 2019, so short-term, high yield corporate bonds will stay attractive. It’s a different story is for bonds with longer maturities, however. While the remainder of 2018 will be underpinned by solid growth thanks to Trump’s policies, we can expect this stop at a certain point next year as rising inflation will require the Federal Reserve to increase interest rates faster, producing a slowdown in the US economy. 

Given this, we are negative longer-term, lower-rated bonds and believe that until year-end, it is the perfect time to get out of these investments as valuations continue to be supported.