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US High Yield: Tempting yields but defaults are accelerating

The year so far has been marked by jittery nerves on the equity and bond markets. Investors are wary of the consequences of a more serious slowdown in the Chinese economy and falling oil prices. Fears are rising over the weakness of the global economy. So what is the right stance to take on the US High Yield market?

We reiterate our very cautious view of US HY. The fundamentals of high-yield issuers are likely to continuing worsening, due to the following factors: 

  • US economic growth remains shaky, with widedisparities between sectors. Growth in the services sector – which has thus far been driven by solid domestic demand – slowed in January far more than expected. The industrial sector is being dragged down by the strong dollar and weak growth in foreign markets. We expect US growth to slow, due mainly to the gradual deceleration expected in the pace of job creations.
  • Corporate earnings are being squeezed hard: (1) there is little room left to improve margins; (2) financing costs have increased; and (3) the dollar’s recent gains has hit exporting companies hard. More specifically, US HY is heavily exposed to the manufacturing sector and, in particular, the energy, metals and mining sectors (17% of the universe).   
  • US corporate debt leverage has not been this high in a decade. In recent years issuers have raised record amounts, mainly on the bond and equity markets, to fund M&A and share buyback.  
  • Financing conditions have toughened in recent months for the most heavily indebted issuers. The percentage of issues with spreads over 1000bp has skyrocketed in the energy, materials and retailing sectors. This points to an increase in defaults in the coming months. The US HY default rate is likely to hit 5% at end-2016 vs. 2.8% currently

With 9% yields, US HY valuations remain far more attractive than European HY, with its yields of only 5%. This difference is due in part to: (1) the European universe’s under-exposure to energy sectors; and (2) the higher credit quality of Euro HY issuers. The European HY default rate should stabilise at its current 2% level. On the dollar credit market, we reiterate our cautious stance on HY and are overweighting IG. We prefer solidly profitable, domestic demand-driven sectors.

 

 

2016-02-05-focus
AINOUZ Valentine , Credit Strategy
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US High Yield: Tempting yields but defaults are accelerating
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