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.

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