High-yield bond market fundamentals are promising, but risks lie under the surface

So far, this year has seen a good market rally, but risks are building, warns Alex Ralph.

The final, turbulent quarter of 2018 ended amid outright panic. Concerns over a slowing global economy grew and liquidity disappeared from some areas of the market. As investors fled riskier markets, government bond markets reclaimed their safe-haven status.

A dovish turn by the Federal Reserve (the so-called Powell put), at the start of 2019 brought a large rebound in asset prices. Markets suddenly became prepared to look past weakness in economic data from Europe and China, and focused instead on a potential solution to the trade war between US and China (and its ramifications for future economic growth).

Fundamentals are sound, but risks are building…

The rebound in markets in response to the “Powell put” has been so fast and so strong that investors could be forgiven for thinking that the final quarter of 2018 was a nightmare rather than a reality.

Our feeling is that the Fed’s more dovish stance, coupled with positive global trade negotiations, has indeed extended the economic cycle. But risks are building, particularly from hard-to-predict geopolitical change.

Fundamentals are fairly good in credit markets, particularly in the high-yield bond market, where default rates seem set to remain relatively low for the rest of 2019. It would, however, be remiss not to highlight some of the risks – particularly in the leveraged loan market.

This market has doubled in size since the financial crisis. A growing number of funds are offering investors daily liquidity in the leveraged loan market, where deals in underlying assets take two to three weeks to settle.

That should be a red flag – the fundamental mismatch in liquidity will become apparent when conditions deteriorate. December gave us a small foretaste of how messy the loan market might get and the potential knock-on effect it could have on other asset classes.

Over the medium term, the most likely outcome would seem to be that markets trade within a range. That range, however, may be somewhat wider than normal and we should be braced for volatility to continue.

Overall, yields in some areas are still attractive, but stock and sector selection will be key. Given the risks that are building, it feels prudent to retain a defensive bias on a sector level.

Alex Ralph is manager of the Artemis High Income Fund.


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