The Fed interest rate decision came and went with relatively little market reaction. They pushed out an increase in rates, citing concerns about global economic conditions. Like many, we do share their concerns about the global economy, as we expect that it will result in muted growth here at home (and as we have noted in prior writings over the past several months, we’d expect that muted growth to ultimately result in a very moderate move in rates). But some market participants are voicing concerns that this global weakness will lead to a U.S. recession. That poses the question, are we headed for a recession, and if so, how is the high yield bond market positioned?
First, our opinion is that while top line demand growth will be constrained for corporate America given the slowdown in global growth (remember China’s growth has slowed, but is still growing), we don’t expect that to lead us into a recession. We have seen three notable recessions during the history of the high yield market: 1990/1991, 2001, and 2008/2009. Each of these was proceeded by major domestic events/issues. In 1990, we were in the midst of facing the Savings and Loan crisis, and the economic situation was further aggravated by the doubling of oil prices as Iraq invaded Kuwait. After a huge rise in the stock market toward the end of the millennium, in 2001 we saw the Internet and tech bubble burst, and that was then followed by the September 11th attacks. Then as we all remember, 2008/2009 saw the housing bubble burst, and subsequent sub-prime mortgage issues, as well as the impact of general over levering in the entire financial system, leading to bank failures/bailouts as the financial crisis ensued. Today, we don’t see any huge bubbles domestically that could weigh on markets as they burst, oil prices remain low, and we see don’t any systemic issues in the financial system, as the various regulations put in place and fear following the financial crisis have left us much less levered. The Fed may eventually start raising rates, but we expect them to be very moderate in their approach, and given their actions so far, they would certainly back off on any rate increase if there was a hint that it was sending us into a recession. So yes, there is global weakness but none of these broader issues to force a recession here at home.
While we don’t expect the current global economic conditions to cause a recession in the U.S., for the sake of argument, let’s look at how the high yield market has performed in past recessions. Looking at these three specific periods, we have noted how the high yield bond market (Credit Suisse High Yield Index) and equities (S&P 500 Index) have performed in the 6 months leading up to a recession (quarterly periods of negative growth), during the recession, and in the 6 months following a recession.1
Excluding 2008/2009, which was certainly an outlier in terms of the severity of the market reaction and the duration of the recession, we have seen high yield bonds perform the worst leading up to a recession. So that then poses the question, if a recession is coming in near future, have we already seen the hit to high yield bonds from it? Of note, in the past six months, we have seen high yield bonds fall -2.9%, and down -4.1% in just the last three months.2 Once we finally got into the recession in both 1990/1991 and 2001 and the period immediately following, we saw the high yield bond market post positive returns. Also of note, in virtually every period, the high yield bond market has outperformed equities.
We are six years into the current economic cycle, but don’t expect that we are hitting the trough in the near term. As we look at the high yield market, we see it as significantly better positioned than we saw heading into 2008, as we haven’t seen massive LBOs and over-levering leading up to this point, we view the problem area in the high yield market—energy—as pretty well contained to those companies and not causing widespread fundamental issues into other industries, and spreads are at what we see as a very reasonable and attractive valuation currently, meaning our market is not near any sort of “bubble” level.
As J.P. Morgan recently noted in one of their reports, “…the broader fundamental outlook remains robust and we continue to expect the credit cycle to last at least a few years and maybe longer. We do believe concerns around oil, the Fed, and China will weigh less heavily with the passage of time, which should clear the way for a partial reversion.”3 We agree and believe that with the currently attractive yield and income generation to be had in the high yield market and potential for spread compression, this market is positioned well. While we don’t expect to see a recession, even if we were to get a mild one on the back of these global concerns, we may well have already seen the return hit to the high yield market as history has shown that to be a leading indicator.
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