The talk of a high-yield bubble and the potential for inflation are likely to remain at the forefront and impact returns throughout the rest of 2011 for the credit markets. Although the list of high-yield market issues continues to grow, two in particular still overshadow the high-yield markets: the high-yield bubble and inflation. Below we provide our view on these two issues and how we are positioning our fund to deal with any impacts.
After a year of record performance in the high-yield credit space, many are making the call that the market is reaching a peak. Historically the market yields 7–8 percent, although it spiked to over 17 percent during the 2008–2009 credit crisis. During the latter part of 2010 and into 2011 yields have declined below 7 percent, driven by a combination of a recovering economy, stronger credit markets, and a historically low U.S. Treasury yield. Despite the low yields, credit spreads remain above historical levels and indicate that return potential still remains in the high yield space.
Credit spreads are more a measure of market risk, as it is the compensation investors receive above Treasuries for holding a bond. Similar to yields, spreads have moved in the same fashion over the past five years, seeing a peak in 2008–09 and then steadily declining. The difference is current spreads are still about 200 bp above pre-credit crisis levels, indicating potential for additional spread compression in the market. Looking at the market from a spread perspective strips out the impact from low Treasury rates and provides a cleaner comparison with prior periods. From this standpoint we continue to see potential upside in the high-yield market as spreads continue to compress, although we expect return to be driving more by individual name selection than broad index buying.
Inflationary pressures have slowly started to show up in the macroeconomic data, but from a bottom-up perspective, the risk of inflation appears more pronounced. In late March, a number of companies including Kimberly Clarke, Colgate, Hershey’s, and P&G announced 5–7 percent price increases. Wal-Mart’s CEO has also come out saying he expects to see price inflation across the retailer. An increasing concern is the relationship between inflation and wage growth, as at the end of March inflation was growing at 2 percent while average hourly earnings were up only 1.7 percent. Companies appear to be using the high unemployment environment to maintain low wages (greater supply of workers = no need to pay higher wages), which should provide a benefit to corporate margins in the short term, but may cause the consumer to cut back spending if inflationary pressures continue. Historically increased inflation has been a near-term positive for the high-yield markets, as it is typically a sign of an improving economy. On a longer term basis, inflation can create a problem for high-yield, which is why we continue to maintain a shorter duration and have increased our holdings of floating rate debt.