We have seen something interesting unfold over the last month in the markets – signs of what we believe are the beginning of a Treasury breakout. Yields are starting to push through levels that have been fairly stable and steady over the last year. Our observation would be that we are starting to see a more secular move out of U.S. Treasuries and other high quality fixed income assets.
Right now, spreads are in the neighborhood of 475bps off U.S. Treasuries. We believe there is room for tightening, but it is getting a little skinny. In terms of yield, absolute yields and high yield (5.6 percent for the index) are weak from a historical standpoint. Bank loan yields right now are in the neighborhood of a little over 4.5 percent. New lows continue to be tested, and there are not big attractive opportunities out there.
So, the question is: Where can you search for decent returns in anything related to fixed income this year?
The overwhelming objection I am hearing is that high yield is excessively crowded and everybody has already bid it up. That being said, it has historically taken anywhere from 18 to 36 months, even after rates have risen, to begin to see an increase in high yield defaults.
This is a critical observation – that an investor can pursue a high yield return dramatically above the default rate, even when it seems to be a crowded trade, or the juice has been wrung from it. Our expectations for defaults are going to be somewhere in the neighborhood of 1 percent – 1.5 percent this year. Part of that is because economic activity is estimated to be between 2 percent – 2.5 percent for the year, and stronger in the second half of the year, which is good for high yields.
Corporations are not taking unnecessary risks and you do not have many trivial leveraged buyouts (LBOs) being done. This is because most private equity firms need much stronger growth in order for corporations to grow into highly levered capital structures. We believe the reality is that we have several more years to go before we have to start worrying about high yield having real problems.
Mike Temple is responsible for oversight of Pioneer’s U.S. credit research department. He has been the Portfolio Manager of an institutional “Credit Opportunity” strategy since 2008, and is also a Portfolio Manager of Pioneer Absolute Return Credit Fund.