Given current valuations and the prospect of rising U.S. Treasury yields in the coming year, we believe that high-yield bonds will produce positive returns in 2014 but will not match the performance of 2013. 2014 will be a “coupon light” sort of year. Under our base-case scenario, we would expect a total return in the range of +4.5-5.0 percent for the global high-yield index. For active managers and for investors who can be nimble and take advantage of a potential short-term correction during the middle of the year, returns could be better.

There are several key themes that we think will dominate in 2014:

·       Corporate profitability will remain solid -- or could even improve from already near-record highs.
·       Defaults will remain subdued, and recovery rates on the few defaults that do occur will be better than average.
·       Capital markets activity will be buoyant and will prove to be positive for high-yield credit overall.
·       Supply will remain robust, but refinancing activity will continue to be the leading use of proceeds for new issues.
·       Demand will remain solid from institutional investors, but retail investors may migrate out of high yield into equities as confidence continues to improve.
·       Government bond yields may be under greater pressure to rise in the U.S. and among some EM countries than in Europe.

Reflecting On 2013
As we establish our road map for the new year in 2014, it may be instructive to reflect on the past year. The global high-yield index produced a total return in 2013 in excess of 8 percent* -- slightly better than most investors expected when the year began and substantially better than all other fixed-income asset classes.

Two big surprises in 2013 were the timing and magnitude of a correction in credit sparked by fears of the commencement of Federal Reserve (Fed) exit policies and the material underperformance of emerging markets versus developed market credits.

Investor fears over Fed tapering were sufficient to roil credit markets and spark a significant correction in the last six weeks of the second quarter.

Emerging markets U.S. dollar-denominated credit posted a loss of more than 3 percent, underperforming the developed market investment-grade Global Aggregate Credit index by more than -2 percent and underperforming the high-yield index by more than -11 percent.  A key question is whether emerging markets debt can bounce back in 2014 and outperform high-yield corporates.

European high yield rallied more strongly than U.S. high yield in 2013, just as it did in 2012, due to an improving macro backdrop, reduced systemic risk, improved sentiment and a normalization of investor positioning. Yet positive technicals have driven valuations on pan-European high-yield credit to be tighter than U.S. valuations. European credit is unlikely to continue outperforming materially in 2014.

Key Trends In 2014
High-yield bonds should outperform other fixed-income sectors in 2014 because of several key factors. First, improving economic growth will be supportive of top-line growth for high-yield issuers. Second, gradually rising Treasury yields will impact other lower-yielding fixed-income sectors to a greater degree than the high-yield sector. Third, strategic M&A activity is likely to increase to a greater degree than new leveraged buyout (LBO) announcements, and continued IPO activity and selective asset sales can contribute to deleveraging in the high-yield universe whereas investment-grade credits are more likely to be releveraging balance sheets.

High-yield credits benefit from deleveraging when private equity sponsors take companies back to the public market in an equity IPO, since cash proceeds from the IPO are often applied directly to paying down debt. We expect the pace of IPOs to continue to be robust in 2014 as stock market conditions are quite supportive and private equity sponsors are motivated to cash out on their investments from the last LBO cycle of 2006-07. This trend should continue to benefit primarily the single-B and CCC credit quality tiers of the high-yield universe.

LBO activity will probably remain more subdued than M&A and IPO activity in 2014. Private equity sponsors are more focused on reaping gains on prior investments, and many have a lower appetite for large capitalization LBO deals after the experience of the last credit cycle and have less dry powder now than commonly reported. Private equity firms are instead focused on acquiring individual properties and smaller assets, since more strategic buyers are competing with them for companies and assets that come up for sale.

Within the high-yield universe, we expect the dispersion of returns across industries and also across different issuers within an industry to increase over the coming year as investors differentiate between the winners and losers and idiosyncratic risk becomes a greater driver of returns.

Key Risk To Monitor In 2014
Investors will need to keep an eye on valuations to ensure that we continue to be amply compensated for risks incurred. Key risks for the high-yield market are default risk, interest rate risk, event risk and changes in the risk premium.  The global high-yield index provides a spread versus duration-matched U.S. Treasurys of more than +360 basis points, which remains well wider than the tights of +225 bps experienced in the spring of 2007, and should be more than ample to cover losses due to defaults. Both interest rate risk and event risk are greater potential threats for investment-grade credit than for high yield. So, as has been the case over the past three years, material changes in high-yield bond spreads will most likely be driven by changes in the risk premium in the coming year as investor risk appetites shift in response to economic data or changes in fiscal or monetary policy.

Periods of volatility can create buying opportunities for investors who are not yet at their target exposure and who seek incremental yield in their portfolio. Any short-term market correction that may unfold in 2014 is unlikely to turn into a protracted bear market because of the macro backdrop. High-yield credit fundamentals remain solid and liquidity profiles are strong since so many companies have already refinanced most 2014 and 2015 debt maturities by extending the terms on bank loans and issuing bonds with maturities in the 2020-2023 range.

Perhaps the biggest threat to the market is the potential for gently rising Treasury yields to morph into a rapid spurt higher, which could become destabilizing for risk assets as happened in Q2 2013. However, inflation remains benign, inflation expectations are unlikely to become unmoored, and the Fed is going to great effort to communicate forward guidance to the market. By issuing forward guidance, the Fed is seeking to keep Treasury yields well tethered through intermediate maturities by indicating no change to the federal funds rate until at least mid-2015, even as it tapers the pace of quantitative easing in 2014. However, investors and financial markets may test the mettle of the Yellen Fed if the economy strengthens and bond market vigilantes drive Treasury yields higher as they fear an overly accommodative Fed sparking inflation.

*The Barclays Global High Yield Corporate 2 percent Issuer Capped Bond Index posted a total return of +8.15% in 2013, outpacing all other fixed-income sectors, and slightly ahead of our own forecast of a 7-7.5 percent return in our publication "2013: A Year in Global High Yield Bonds," which came out last year at this time.

Wesley Sparks is the Head of US Taxable Fixed Income at Schroder Investment Management North America Inc., which he joined in 2000. Wes oversees a team of 18 professionals in the US Fixed Income group in New York. The team manages approximately $11 billion in assets across a number of institutional accounts, including public and private pension funds, Taft-Hartley accounts, insurance companies and mutual funds. Wes was the Head of US Credit Strategies prior to assuming the role of Head of US Taxable Fixed Income in September 2008. As a portfolio manager, Wes’s expertise is in the corporate bond sector. Wes built Schroders' high-yield team over the past five years, and he has been the Lead Fund Manager for Schroder ISF Global High Yield since its inception in April 2004. He is now Lead Manager on a number of other mutual funds, all of which are managed on a team basis.