Now that Donald Trump has surprised virtually everyone with his Presidential victory, what does that mean for the high yield market? For us, it looks like the most relevant impacts are interest rates, taxes, and regulations.
First, let’s look at interest rates. The 10-year Treasury has gone from 1.83% on Monday, November 7th, the night before the election, to cross above 2.3% over the course of the next couple weeks. Yes, this is a sizable move and has been primarily attributed to a couple of underlying factors, both of which we view as potential positives. First is the expectation that the Trump/Republican initiatives, including infrastructure and other government spending, will drive economic growth. Second is the idea that with a Republican controlled House and Senate, tax cuts are very likely to get passed, and those tax cuts in turn could cause demand-pull inflation. There have been promises of tax cuts on both the individual side, putting more money in the pockets of the consumer, and on the corporate side, allowing for greater profits which can in turn be invested in growth and capital spending. Additionally there is the discussion of a corporate “tax holiday,” allowing corporations to repatriate cash held overseas, which they can then apply to things such as stock buybacks or debt reduction. We know that consumer spending is nearly 70% of GDP and corporate spending another sizable piece of the pie, so whether it is tax cuts putting more money into the hand of the consumer and corporations or the infrastructure spending improving the job situation, we would see both as positives from an economic growth perspective.
Prices of high yield bonds have historically been much more linked to credit quality than to interest rates. The biggest cause of spread widening (price declines) over the years has been spikes (or anticipated spikes) in default rates.1
On the flip side, historically, interest rates are usually increasing during a strengthening economy and a strong economy is generally favorable for corporate credit and equities alike. We believe investors should focus on default/credit risk when investing in the high yield sector, paying attention to the company’s fundamentals and credit prospects. When the economy is expanding, profitability, financial strength, and credit metrics generally improve. Additionally, if corporations have more money in their pockets due to lower taxes and repatriation of cash that can allow for more money to service and pay down debt, further keeping default rates at bay.
After years of muted economic growth, during which the broad high yield market has still performed well, we would view a stronger economy as undoubtedly a positive from a credit perspective if it were to come. Under this scenario, default rates (excluding energy/commodities) should continue their below average trend and we would expect high yield debt to be positioned well for yield generation and returns potential going forward. For more on our thoughts on the economy, rates, regulations, and the outlook for the high yield market as a result of the recent election, see our piece “The Election Impact on High Yield: Rates and Regulation.”