Historically, January has been high yield’s strongest month, with a positive monthly return in 26 out of the last 31 years, or roughly 84% of the time. We can see this (outlined in orange) in the following table highlighting the monthly returns of the Bank of America Merrill Lynch US High Yield Master II Index Total Return. Not only does January historically have the highest percentage of positive months, it also has the highest average return at 1.6%. January of 2017 was no exception to this amazing seasonal pattern of high yield returns, propelling the High Yield bull market forward for another month.
Source Bank of America ML US High Yield Master II Index Total Return
High yields have reacted very favorably, along with many other domestic asset classes, to the election of President Trump as a reflation trade has been ignited, helping to lift US markets higher on optimism for new policies. The prospect of tax cuts, reduced regulation, and infrastructure development projects such as pipelines, bridges, and the planned border wall have been met favorably by the markets.
The risk-on environment that started in late 2016 has transferred over to 2017 without much of a problem in the high yield market. Investors in the riskiest slice of the high yield market, CCC-rated bonds, have enjoyed the strongest returns year-to-date. In January, spreads on CCC-rated bonds over Treasuries tightened by a relative 9.2%, falling from 9.7% to 8.8%. For comparison, the spread on BB-rated bonds tightened just 2.6% during the month, from 2.7% to 2.6%. The differential in spreads between CCC and BB’s ended the month at 6.18%, the narrowest margin since May of 2015.
A portion of the CCC outperformance may be due to investors reaching for yield, but it is also reflective of a decrease in perceived credit risk. The trailing 12-month default rate in January was unchanged from the month prior at 4.6% and Fitch Ratings analysts anticipate a decline to 3% by the end of 2017. The energy sector trailing 12-month default rate, which currently stands at 19%, is also expected to end the year around 3%. Oil will likely remain range-bound in the $50-$65 range as supply and demand finds equilibrium between OPEC production cuts and increased output from US shale drillers. Even if oil prices were to unexpectedly plunge, many of the US drillers have hedged their downside risk by locking in prices at profitable levels above $50.
New issue volume in the high market was strong in January with $26.5 billion of new bonds coming to market across 49 transactions, the high issuance rate since last September. High yield issuance in 2016 amounted to just under $245 billion, the lowest dollar volume since 2009. Most forecasters are anticipating a surge in mergers and acquisitions in the coming year, resulting in a slew of new high yield debt offerings.
All of these indicators are supportive of continued strength in the high yield market. While spreads have tightened to levels that would cause some to deem high yield to be overvalued, there remains some room for the current rally to run. Interest rate risk should remain in check as the Fed will be hesitant to rock the boat and likely won’t hike rates until June at the earliest. The expectations of improving economic growth combined with low high yield defaults provides a strong tonic to power the increase in demand for high yield investments and keep the bull market going in 2017. Hanlon is optimistic and our Tactical models remain fully invested in domestic high yield bonds at this time.
The Bank of America Merrill Lynch US High Yield Master II Index Total Return is a composite index for high-yield U.S. Corporate Bonds. Past performance is not a guarantee of future results. This Market Commentary is limited to the dissemination of general information pertaining to its investment advisory services and is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock and bond markets involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice. Hanlon has experienced periods of underperformance in the past and may also in the future. The returns represented herein are total return inclusive of reinvesting all interest and dividends. Hanlon Investment Management (“Hanlon”) is an SEC registered investment adviser with its principal place of business in the State of New Jersey. Hanlon and its representatives are in compliance with the current registration and notice filing requirement imposed upon registered investment advisers by those states in which Hanlon maintains clients. Hanlon may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing re-quirements. Any subsequent, direct communication by Hanlon with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Hanlon, please contact Hanlon or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Hanlon, including fees and services, send for our disclosure statement as set forth on Form ADV from Hanlon using the contact information herein. Please read the disclosure statement carefully before you invest or send money. Not all Hanlon clients are in the strategies discussed herein.