Manager Insight

Amid narrowing spreads, non-investment-grade credits are expensive, Greg Kocik says.
By Michael Ryval | 20/07/17

With high-yield-bond spreads over U.S. Treasuries approaching relatively low levels, and uncertainty about the Federal Reserve's plans to start the process of unloading trillions of dollars of bonds from its balance sheet this fall, Greg Kocik argues that it is a time to adopt a conservative stance.

About the Author
Michael Ryval, a regular contributor to Morningstar, is a Toronto-based freelance writer who specializes in business and investing.

"Clearly, the market is much more expensive than a year ago, after a very strong rally," says Kocik, managing director at Toronto-based TD Asset Management Inc. (TDAM), and lead manager of the $1.2-billion TD High Yield Bond. "But the question is: Where are we in the cycle, and is the current spread of 395 basis points (bps) comparable to where the market was trading, say, 10 years ago, just before the financial crisis?" In July 2007, spreads were 250 bps, an all-time low. That suggests, Kocik notes, that there is some cushion in the current spread.

On a positive note, Kocik adds, there is less interest-rate sensitivity in high-yield bonds as the effective duration has slipped to about four years, from 4.4 years in June 2007. As for the quality of bonds, the average credit rating, B-plus, has not changed in a decade.

"In addition, after the commodities 'recession' of 2014-15, there don't appear to be major imbalances, such as excesses in housing and auto supply, within the U.S. and other developed economies. This suggests that it is not as bad as it was in 2007, in terms of valuation," says Kocik, adding that the all-in yield is now about 5.75% for the broader U.S. high-yield market.

The market has experienced two big selloffs in the last seven years, starting in 2011 when U.S. government debt was downgraded, followed by the energy sector meltdown in 2015-16. This begs the question: is this current period the so-called quiet before the next storm? Kocik replies: "The energy sector had a big shock and that has been pretty much fixed. But what's next? Is everything good in the world, or are we approaching some sort of turning point?"

It's not the fact that the Federal Reserve is in a tightening mode that concerns Kocik. It's his belief that the market is unprepared for the Fed's balance-sheet adjustment, potentially starting later this year, and not investing the proceeds of the trillions of dollars in bonds. "They may not sell them. But, net-net, it's just an additional supply of bonds in the market."

Kocik observes that the high-yield sector stopped rallying in April. And since then, the Fed's balance sheet is "one of the issues that people are trying to figure out," he says, adding that the recent drop in the crude oil price has also added to the uncertainty.

"We are very cautious on high yield," says Kocik, a 27-year industry veteran who has an MBA from the University of Western Ontario and joined TDAM in 1997. He has managed the high-yield bond fund since 2000. "The economy is fine, but at this stage of the cycle you will see more shareholder-friendly activity by companies, such as leveraged buyouts and dividend payments, which will probably be funded by high-yield bonds or some other bond issuance. That will only add more supply, and may eventually depress the price of bonds."

If, in fact, North America is in the late stage of the cycle, there would be significant widening of the spread, says Kocik. "The high-yield market is okay if economic growth is about 1-2%. But if it dropped below 1%, there would be a selloff. That's not our base case, though we do think about it."

In the current environment, Kocik maintains he can still find high-yield bonds that can deliver mid-single-digit returns, which is still attractive compared to government bonds. "There are a lot of short-duration, former investment-grade bonds that were downgraded after the financial crisis, and then the energy crisis, and are maturing in three to five years and yielding 4% to 5%. We can hold them for several years and collect the coupon."

From a strategic viewpoint, Kocik is fully invested and invested primarily in the U.S. He owns about 180 bonds issued by 110 companies. "We have a bias to the non-cyclical part of the economy," says Kocik.

Some of the bonds that he likes include those issued by HCA Healthcare Inc., the largest hospital operator in the U.S. It has a Feb. 2020-dated bond that is rated BB-plus/BBB and yields about 3%. "They could become investment-grade if they stopped buying back stock. They're just a bit aggressive in terms of using cash flow to pay shareholders. But it has over 100 hospitals and is a very stable player in the sector, and the bond is maturing in less than two and a half years."

Another favourite issuer is Ally Financial Inc., the former financial arm of General Motors Corp. "Even though auto sales are declining now, we think that Ally can easily manoeuvre through any downturn in auto sales. The bonds would have been investment-grade were it not for the recent levelling off in sales and some share buybacks." The September 2020-dated bond, rated BB-plus, is yielding 3.5%. "This bond is in fairly high demand. If something bad happened in the bond market we can easily sell these bonds."

Significantly, Kocik is cautious on effective duration, which is currently 2.6 years, or 1.4 years below the benchmark Bank of America Merrill Lynch BB-B U.S. High Yield Index (hedged C$). "We are concerned about the rationalization of the Federal Reserve's balance sheet and how it might spook the broader bond market. That could put pressure all bond markets, including credit, even though the economy is strong. A strong economy is a good thing for high-yield because it means strong profits. However, the disruption in the bond markets could be meaningful and may result in a slower economy."

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