Outlook 2015: Junk market survives Fed tapering – but oil slide emerges as challenge for 2015

By Paul Deckelman

New York, Jan. 2 – If it isn’t one thing – it’s another.

That bit of conventional folk wisdom – lamenting the fact that one can overcome one obstacle, only to be suddenly confronted with a different, and usually unexpected challenge – was borne out in Junkbondland in 2014.

Market participants had gone into the year anxious over what impact the previously announced and long-dreaded “tapering” by the Federal Reserve System of its expansive quantitative easing bond-buying program would have on the overall U.S. economy and on the fixed-income markets, particularly high yield.

Would gradually turning off the $85 billion per month liquidity faucet start pushing interest rates higher, to the point that they would damage the economy and adversely affect bond returns?

Bond marketeers held their collective breath as they waited ... and not much happened.

The Fed, as promised, began tapering in January, reducing its bond-buying by $10 billion that month – and by the end of October, the tapering program had been completed, without incident. Interest rates, far from pushing higher, declined over time; minor temporary upward ticks not withstanding, the benchmark 10-year Treasury yield eased from its perch slightly above 3.0% in January to just a few basis points over 2.0% by mid-December.

But while investors were busy watching the QE3 sail off into the sunset, few initially really noticed as a black swan appeared on the horizon – the inky dark color of its plumage not unlike that of the thick liquid that bubbles up from the ground when petroleum is drilled.

Crude oil prices, which had traded safely and profitably above the $100 per barrel mark since the start of the year, began slowly coming down from those peak levels starting in July, pushed lower by a combination of more-than-ample supply meeting less-than-adequate demand.

The January futures contract for West Texas Intermediate crude had eased down to below $90 per barrel by Oct. 1, then to around the $80 level by early November – and had plunged into the 60s by the end of that month, after OPEC ministers chose to take no concerted action to rein in supply. Within two weeks after that, by mid-December, crude prices had cascaded down to the mid-50s – and now everyone was paying attention.

The steadily eroding oil prices in turn began inexorably pushing the bonds of high-yield oil and natural gas exploration and production companies lower; before long, multiple-point drops in heavy trading became the norm, particularly once December hit – and that, in turn, began dragging the overall junk market down. By mid-December major indices were virtually flat versus where they had begun the year; any gains they had were gone.

Oil holds key to 2015 results

Heading into 2015, junk bond traders, analysts and strategists queried by Prospect News said that at least for the near-term, the fallout from this continuing turmoil in the energy market would be the key determinant of which way junk bonds will go in the new year.

Further crude price deterioration and price losses among energy credits will weigh heavily upon the performance of widely followed market-performance indexes, since energy issues carry a prominent weighting in those market gauges. Nervous investors pulling money out of mutual funds will trigger forced selling of other bonds, even well beyond the energy sphere.

On the other hand, they believe that lower oil prices will act as a stimulus to the economy, benefitting companies and industries which themselves buy substantial quantities of fuel or oil for use as a raw material, as well as sectors dependent on consumer spending – with money that consumers were spending at the gasoline pump or to heat their homes now available to buy other things.

And although oil prices will open the new year at the lowest levels seen in years, many of our respondents believe that there may be value to be had in the battered energy sector as well.

A tale of two markets

As has been the case several times in recent years – 2011 and 2013 come readily to mind – 2014’s high-yield market was a bifurcated creature.

In each of those years, the market started strong but ran into problems around the middle of the year. In 2011, it had been a combination of the European sovereign debt crisis and the volatility arising from the domestic debt ceiling problems and the first-ever downgrade of the formerly sterling U.S. government credit rating.

In 2013, it had been investor angst over the possibility that the Fed might end QE3, later reinforced by official announcements that this, in fact, would be the case.

In each of those earlier years, though, the junk market had managed to right itself by the end of the year; it managed to eke out around a 4% gain in 2011 – although that was below earlier expectations – while in 2013, returns were actually fairly respectable.

The Merrill Lynch U.S. High Yield Master II index closed out that year on Dec. 31, 2013 with a 7.419% return, a yield to worst of 5.671% and a spread to worst versus comparable Treasuries of 418 bps. The average price for an issue covered by the index was 103.3161.

In 2014, on the other hand, “we started out with pretty good returns – but they got pretty ugly by the end of the year,” said Mark Pibl, the head of high-yield strategy at Canaccord Genuity Inc., a Toronto-based global investment banking and wealth-management firm.

He said that the market was doing well through the end of June, with returns by that point north of 5%, “but then just fell off the cliff.

“To a large extent, we gave it all back, and then some, though the second half of the year, with really big spikes in volatility.”

Mathew Van Alstyne, the chief of research at Odeon Capital Group LLC, a New York-based boutique broker/dealer, investment banking and asset-management firm, said that “the first half of the year was totally different from the second half. Generally, bond prices steadily crept up in the first half, and I didn’t feel like we felt that much volatility – we may have had a few spots here and there, but it really wasn’t that volatile.

“As QE ended and as we got into the end of the year and oils were trading off, it seems like we were in a totally different market. It’s a tale of two different years with bond prices now.”

The Merrill Lynch index for 2014 bears that out.

Riding the momentum generated at the end of 2013 and fueled by ample investor liquidity, the index came roaring out of the gate, and had reached a return of 5.727% on June 24, its peak level for the next few months. Around that time, other components of the index hit their strongest levels of the year, including a yield to worst of 4.847% on June 24, which was not only its low for the year but also an all-time low.

The spread to worst notched its tightest level for the year, 353 bps, on June 28, while the average issue price had shot up to a 2014 high of 105.9617 by June 24.

Momentum changes

At that point, negatives began weighing on the market. The index’s return slid throughout July, reaching an interim low of 3.683% by Aug. 1, but then coming back up to hit its high point for the year at 5.847% exactly one month later, on Sept. 1. After that, though, it was pretty much all downhill from there.

From levels around 4.2% just before Thanksgiving, the index’s cumulative return had plummeted 1 full point to 3.32% in the space of a couple of days by Dec. 1 – the market’s first full trading session after the failure of OPEC to curb overproduction at its meeting the previous Thursday.

By Tuesday, Dec. 16, with the energy sector in freefall and the overall market moving lower as well, the Merrill Lynch index’s total return had slipped into the red, showing a cumulative loss of 0.258%.

It was not only the first loss of the year, but the first time the index had shown a negative return at all since October 2011. Its yield to worst, meanwhile, stood at 7.259%, a new high for the year to that point, while its spread to worst was at its widest point in 2014 to date, at 576 bps. The average price had fallen to 96.4866, a new low for the year to that point.

Other market measures told an equally bleak story as 2014 was ending; the KDP High Yield index, which had closed 2013 with a reading of 74.42 and a yield of 5.62%, ended on Dec. 16 at 69.01 – its lowest finish since October 2011 – and with a yield of 6.43%.

Mid-year malaise

A trader said that the junk market started retreating after hitting its late-June highs due to several factors.

For one thing, he said, statements coming out of the Fed indicated that the central bank might be taking “a more hawkish posture,” in terms of when it might go back to raising rates.

He said that got people to worrying that with the tapering process almost done, rate hikes would necessarily follow, and rates did start pushing back upward at that point – the 10-year Treasury rate had dropped from around 2.6% in June down to a mid-summer low just under 2.4%, only to come back up to the 2.6% level by September.

After that, though, he said that “as the year went on, people became more and more sanguine about the fact that the Fed had no alternative but to maintain a low-interest-rate stance.”

This was reinforced in late October when the Fed announced the final end of QE3, but took pains to assure the financial markets that it would hold its Federal Funds target rate between zero and 0.25% for a “considerable time” after the program had wrapped up – although the central bank left the door open to begin hiking rates sooner than anticipated should the economy improve faster than expected.

On top of lingering interest rate worries, he cited the beginning of moves toward the implementation of the Dodd-Frank regulations overseeing the financial industry. Those rules, which became law in 2010 in the aftermath of the 2007-2009 financial crisis, “regulate what the banks can own, what they have to reserve as capital and what capital they have to have as Tier 1 and Tier 2. That’s become very onerous. That’s why the entire Street has reduced their overall positioning capability in fixed-income securities, not just high yield.”

And on top of that, of course, were oil prices, which began drifting a little lower over the summer – but that initial slow downward drift had turned into a runaway freight train by the end of the year.

Market roiled by oil

A junk market trader declared that “if you had said – even during the summer – that oil is going to be at $60 per barrel, or even below that, by the end of the year, people would have said ‘get the heck out of here’ – and look at it now; every day it just keeps dropping.”

A second trader cited the failure of the OPEC oil ministers to agree to production curbs at their meeting in Vienna on Nov. 27 as the inflection point where the retreat turned into a rout.

“I’m very surprised that OPEC didn’t do something a little more rational – but who knows what’s going on over there?” he said.

Odeon Capital’s Van Alstyne said that the “the biggest surprise [of the year] is just oil prices collapsing with no support. I think no forecaster, and no one predicted sub-$90 oil at all for any moment in time in the next 18 to 24 months, and now we’re wondering if it’s going to $50.”

He noted that “a lot of the high-yield issuers happen to be in the energy space, or are correlated to the energies, and so that particular situation is going to be damaging to the market.”

Canaccord Genuity’s Pibl noted that “energy is about 15% to 17% of the high-yield cash bond index. It’s even a larger percentage of the more actively traded names.”

Bonds of many of those names – what he called the “regular plain-vanilla E&P companies” – had fallen almost 20 or 30 points, some even more, within the last four weeks or so.

One such name, for instance, was Halcon Resources Corp., whose three series of actively traded bonds had hovered around or above the par level in early October. The Houston based E&P company’s paper was still trading in the mid-to-upper 80s in mid-November, but it had all fallen as low as around 65 bid by mid-December.

“So having that big a percentage-move down has been weighing on the [overall] index,” Pibl said.

At BofA Merrill Lynch, Michael Contopoulos, the head of high-yield credit strategy, said that BofA had been bearish on energy as 2013 closed out, recommending that clients underweight the sector during the coming year. In that, he noted, “I think that we were the only strategists that I know of on the Street, and probably some of the only market participants in general, who were underweight energy going into 2014.”

Although he had been prescient about energy as a potentially troublesome sector, Contopoulos readily admitted that “even though we got that call right, I never thought that we would be down 20 or 30 points, as we have been on many of these names, in a very, very short horizon.”

More oil troubles ahead

Although some energy bonds have been battered pretty badly over recent weeks, Contopoulos warned that the carnage is probably by no means over.

“I think oil [price] volatility is going to lead to more pain in the energy space,” he cautioned.

“I think that clients, and real-money clients in particular, are overweight this sector and can’t get out of small, little names that they’ve bought over the last three or four years,” due to a lack of liquidity and markets in those issues.

“I don’t think that we’ve really seen the full selling pressure in those names – there’s still quite a ways to go as far as the energy story is concerned and how much further that can drop.”

Underweight these sectors

For that reason, BofA is once again underweighting energy, as well as two other sectors that it had underweighted in 2014 – the materials sector, which includes metals, mining and coal, and retail. Contopoulos said that three sectors represented three out of the four biggest underperformers in 2014 and are not likely to improve during the year ahead.

A trader said that “I anticipate that anything with oil-related companies is going to have problems, whether the producers or the service industry. That’s going to be an unknown – how much the drop in energy prices is going to affect these companies. I don’t think we’ll really know until the earnings start coming in, and so forth. They certainly have been knocked down pretty hard over the last three months.”

Another trader said warily that although he expects oil prices to recover to somewhere in the $70 to $80 per barrel area, “if they drop to $50 and below, you can expect the default rate in the energy sector to hit double-digits” – perhaps as much as 15% to 20% of the sector.

Odeon Capital’s Van Alstyne, quoting Warren Buffett’s well-known line about learning who has been swimming naked, once the tide goes out, opined that many oil companies “have a little bit of swagger – they’re confident, and they think they have their long-term [hedge] contracts and can probably survive $60 oil for quite some time. The question is, when people stop surviving and need to be thriving, who’s going to start missing coupon payments? Where are the surprises on defaults and on the ability to fund their capex programs?”

He allowed that this “disparity between the haves and the have-nots” in the energy business probably would not show up “for quite some time. Maybe in a year it will be more of a hot story that guys are actually missing some coupons, whereas now, people are saying ‘if we stay at $60 oil, there’s a potential.’ So I think as the year goes on, it will actually be more of a drag on prices.”

Not necessarily a disaster

While the fall in oil prices to their current levels clearly blind-sided the market, and current trading levels for bonds in that space are indicators that investors should tread and trade cautiously there, it is by no means a given that they should simply write off energy in the coming year as a sector better left unvisited.

Kingman D. Penniman, the founder and president of KDP Investment Advisors, Inc. in Montpelier, Vt., said that the junk market “clearly did not see the pressures we are currently witnessing,” particularly as regards the breathtaking collapse of oil prices, and along with them the spectacular fall in many energy-sector issues.

“The roller-coaster ride and volatility can continue in the short-term,” but he added that “the demise of energy credits, and the high-yield market in particular, is greatly exaggerated.”

The current situation, he said, “should not have a long shelf life. To the extent that market participants will be more discriminating and more conservative going forward, the better.”

Penniman said the big question at this point is “how low can prices go – but more importantly, how long can they stay low?”

His shop, like a number of others, is modeling its 2015 assumptions for the high-yield energy sector on an average $65 price for a barrel of crude oil, even though that downside support level has now been breached. He expects that to reach that $65 average figure for the year, prices will be “sharply lower in the first half [of 2015], before rebounding into year-end – not the end-of-the-world scenario.”

OPEC, as well as such large non-OPEC producers like Russia and Mexico, might be inclined to re-think November’s decision to not cut output, possibly “well before mid-2015.”

He said that “our outlook on the markets is that the more oil prices plummet and inflect pain, the sooner there will be a resolution so the markets can stabilize.”

Fundamentals still strong

Despite the financial markets’ reaction to the oil-price slide, battering down both the bond and share prices of many E&P companies, as well as those in closely aligned areas such as drilling and other oilfield services and midstream companies specializing in the transportation and/or storage of crude oil and refined product, Penniman said that fundamentally, the majority are still strong.

Even assuming that energy prices will continue to retreat at least for the first half of the new year, “a lot of these companies have the liquidity and the capability to get though that period,” he said.

“Most of the companies that we see are not going to have a problem in 2015,” even in the current low-oil price environment,” he asserted.

For one thing, much of their production for the coming year has already been hedged to protect against further large downside price moves and they have adequate capital on hand to ride out the storm. Given the junk and leveraged loan markets’ big refinancing boom over the past few years, with issuers taking advantage of historically low rates to push out their maturities and lower their overall financing costs, “many of these companies don’t have a lot of financing coming due.”

Penniman said that just looking at “where the pressure seems to be, in shale, there’s still a lot of high-quality oil companies, BB-type credits, who are the survivors and yes, you may not know where the bottom is, but I think longer-term, it’s going to provide a very attractive return potential, both on carry and when the capital appreciation comes back.”

He continued, “When we look at some of the oil plays, we do see some good credits and opportunities here to pick the credits,” although more conservative investors may choose to hold back until the oil price situation shakes itself out “because you just don’t know.”

And he said that KDP is “looking at the loans too – there are a lot of offshore drillers that have loans that are fully collateralized, whose loan prices are trading at very depressed levels. So I think that’s one sector.”

A trader agreed that “there are going to be places in energy to pick up – but it’s going to take a while to shake out.”

He cautioned that “it’s going to be a dicey game picking those winners and playing that space in the short-to-mid-term. I believe the landscape is going to be harder to pick names and generate returns.”

Energy “is going to be a spot to step into – but it’s just a matter of timing and the quality of the credit you’re stepping into.

Market players eye energy

Despite the energy sector’s obvious problems, Canaccord Genuity’s Pibl said that he “would not be negative on energy now, after the damage has been done – that’s the wrong thing to do.”

Despite the risks involved, some investors may be attracted to energy, feeling that the yields on sector credits – some of which had been yielding 7% a few months ago but which have now moved up to around 17% – make those names potentially attractive, especially since many of the companies have hedged much of their 2015 production to limit the impact of further big downside price moves.

Many of those more adventuresome investors might wait and see whether oil prices find a bottom in the coming year before pursuing such a strategy – and Pibl said that all that would be needed in that case would be “a sense that oil has found a bottom; it doesn’t need to go [back] to $90, it just needs to stop going down.”

Some bets being placed early

He said that based on what he has heard in talking to numerous accounts, there are even some investors who “are not waiting for next year” and are making such bets now.

And while the recent carnage in the energy space has hammered down the major junk market performance indexes – heavily populated as they are with energy names – Pibl pointed out that surprisingly, some investors and asset managers profitably eschew the common practice of weighting their portfolios to mimic those popular indexes and choose instead to be more diversified holders.

“So what happens is, if you’re an index-weighter and the index is 20% energy, you need 2 out of 10 of your portfolio issues to be energy just to achieve a marketweight,” and some such investors may even have as many as three credits out of every 10 in energy. “But if you’re a normally diversified asset manager, you do less index-matching, and you might have just 1 out of 10 out of your portfolio holdings in energy. So by definition, you’ve outperformed [the index-weighters] by not having that exposure – so it allows you to move into these names at these lower prices.”

While oil is the dominant component of the energy sphere and its price fall has thus toppled the bonds of many energy companies like so many dominoes, it is by no means the only such component.

Natural gas firms will be OK

A trader noted that natural gas companies “will do fine” – an interesting twist given that just a few short years ago, in early 2012, gas prices on average were languishing at or even below $2 per million BTU, making it uneconomical for gas-intensive operators to continue to pour capex money into new wells.

Many like Chesapeake Energy Corp., at the time the second-biggest U.S. gas producer behind industry behemoth ExxonMobil Corp., began shedding gas assets and moving more of their production into oil. Gas prices eventually rebounded, even spiking slightly above $6 earlier this year; they were still as high as around $4.60 in early November, although they had come back down to around $3.75 by mid-December, which most analysts consider to at least be a sustainable level for the companies.

He also touted the propane companies, declaring that they too “will be fine, because most of the propane issuers in the high-yield market are really distributors, they are not manufacturers or producers.”

On the other hand, in the coal area, “you’ve got a couple of companies yielding in the 5% or 6% range – and everybody else appears to be in trouble” – credits such as Cliffs Natural Resources Inc., Walter Energy, Inc. and Alpha Natural Resources, Inc.

“As long as [president] Obama is in the White House, I don’t expect significant relief for the coal industry,” given the stringent air-quality regulations imposed on power plants – major coal customers – by the Environmental Protection Agency, although he said that the change of control on Capitol Hill might lead to “less targeting of coal” from a legislative perspective. Even so, he said, “coal is under siege from the government and now, oil prices and natural gas prices.”

Energy M&A a possibility

With energy prices having been driven down and the equities and debt of companies in that sector pulled down along with them, could some of those companies become targets for takeover or other merger-and-acquisition activity?

Odeon Capital’s Van Alstyne said that such scenarios are possible.

“I think historically you see more M&A activity when energy prices are weak than when they’re strong because when they’re weak, it gives the acquirers – the people who have cash – a much stronger hand, because they’re trying to buy people that need cash, whereas when energy prices are high, prices tend to be higher than bargain-basement levels.”

However, he added, it would depend upon whether the target company was so badly distressed that it might be potentially headed for a bankruptcy situation, in which case, “the question would be – especially if we’re talking about a levered company being the target – do you want to buy it with all its debt? Or would you wait for them to file for bankruptcy and try and buy its assets after it’s wiped out that debt?”

For somewhat less-levered companies who merely find that their planned capital spending is constrained by decreased revenues, “I would think that it definitely would drive M&A activity.”

Who benefits from oil’s fall?

The flip side of the damage that falling oil prices have done to the energy sector and through it, to the overall high-yield market, is that some sectors and segments will benefit.

The most obvious beneficiary would seem to be market segments dependent upon consumer spending, as hard-pressed consumers are suddenly getting a windfall.

One SUV-driving trader said that once his interview for this article was over, he was going to leave the office “and go top off my [Chevy] Suburban –every day I go by the gas station, it’s two-to-four cents cheaper by the gallon, as oil keeps going down a dollar or two dollars a day.”

He added that “I pity the portfolio managers [who are long on energy-related credits] – but they don’t have to fill up that huge gas tank, twice a week, like I do.”

Several of the people we spoke to used some variation on the idea that the fall in oil prices and the resultant slide in consumer costs at the gasoline pump or paying the home heating fuel bill amounted to an economic stimulus – one called it “an immediate tax break for most consumers” – and that money would be put to good use.

One trader, for instance, said that “with gas at $1.75 or $2 per gallon in some places, versus $3 or $4 before, it adds up. That should provide some strength to consumer product areas, retail, specifically.”

He said that “we also could see some strength coming out of gaming – a little more disposable income, maybe in the lodging/leisure sector, a more vibrant consumer should be the by-product of a supportive Fed and cheaper oil prices.

“And we could see some improvement in the auto area – again, cheaper gas prices, auto suppliers, possibly.”

He said that it was “pretty obvious” that airlines – huge consumers of jet fuel – should do much better with lower oil prices.”

Others expected to benefit might be industrial companies who are big buyers of petroleum-based compounds for use as their basic raw materials – chemical producers and plastics manufacturers, for instance – although one of the traders said that “we could see some volatility in the chemical space as oil prices move up and down.”

Retail has its own problems

While several of those queried seemed constructive on retail, others were cautious about the sector, some of whose names have been taking their lumps this past year.

Bank of America’s Contopoulos, for instance, said that “the problem with U.S. high-yield [retail] companies is really structural issues with that sector – and no matter what stimulus is given to the consumer, names like J.C. Penney and Sears, Gymboree, Claire’s Stores and RadioShack are probably not going to perform significantly well [in 2015], regardless of low oil prices, because these guys are just sort of structurally broken.”

KDP’s Penniman essentially agrees that “on retail and supermarkets, it’s really a bifurcated market – we like the strong companies, but it’s very hard to get too excited about the retail and the big-box stores, given everything that’s been happening with [e-commerce on] the internet and some of the supermarkets. Some of them are doing well, some aren’t, but we would be looking selectively there.”

Likewise, he said that the airlines, “can be a very volatile sector in high yield” – the parent companies of some major U.S. carriers like low-cost titans Southwest Airlines and JetBlue comfortably cruise the skies with investment-grade ratings, while traditional legacy carriers like Delta Air Lines Inc., United Continental Holdings Inc. and American Airlines Inc. are flying junkers, sometimes buffeted around in recent years by financial turbulence. “But obviously, they’re doing better, both between the [increased passenger] traffic and the lower oil prices.”

Other sectors that Penniman likes include telecommunications, which he said will “still remain strong,” and cable, as well the consumer sector. He said “we weren’t that enthused a couple of months ago” about consumer-driven names, but with recently improved sales numbers, “it looks like the consumer sector may be another sector to go back to,” as opposed to cyclicals, which could be impacted by lagging global growth trends.

Consumer-oriented space eyed

Canaccord Genuity’s Pibl is also constructive on some of the consumer-oriented sectors, which he said should do well, particularly if there is a knock-on effect on consumer spending from suddenly lower energy costs.

Autos, he said, have been “very good, they’ve been very strong,” specifically in the auto parts segment. He noted that auto sales have lately been robust, particularly in November, when “these guys were discounting and moving inventory, so that bodes well.”

Consumer products, he said, should actually benefit from the low-oil price environment due to lower raw material costs, while housing has also been a strong sector.

Retail, he said, “has been bifurcated” – some of the names have done well, while others have struggled, but overall “it has had a good run.” He cautioned, though, that “it remains to be seen if the lower-commodity oil prices will be a jolt to consumer spending.”

Odeon Capital’s Van Alstyne believes that consumer names, utilities and transportation and rails “would be areas where you could see not just solid gains, but much more solid than expected, because they are going to be supported on the revenue side and on the cost side, so you’d see profit margin expansion as well, which would help credit prices.”

Financials raise questions

On the other hand, he is wary about the financials, which he calls “a question mark.” How the sector does “will really depend on whether or not borrowing returns and lending from banks comes back.” Another factor adding to the uncertainty, he said, “is how Dodd-Frank gets implemented and trading volatility comes back.”

How housing does, in turn, will be largely tied to the banking sector, “whether or not that loosens up, as opposed to the overall economy. It’s there and could boom – if people can get access to credit.”

A trader said that personally he’s “not a big fan of homebuilders at current levels, but there are a lot of people that are.”

And despite the belief in some quarters that lower fuel prices and more money in consumers’ wallets might help the casino industry, he’s wary about that sector, especially given the ongoing deconstruction of its once-profitable Atlantic City component, hurt by new competition in New Jersey’s neighboring states of New York, Pennsylvania and Delaware. Four of the seaside city’s casinos closed this year alone, leaving eight still operating; who knows whether Las Vegas bookmakers may soon start giving over/under odds on how many will still be open for business a year from now?

“I just think they’ve borrowed a lot of money to build these palaces that nobody is really going to anymore,” he intoned.

On the upside, he said, “the two sectors that could really have some upside volatility are parts of the energy sector and retailers.” He said that neither of those entire industries “will go bankrupt, and right now, many of the credits in those two sectors are yielding between 10% and 20% – so I would say that any improvement in those two sectors make them the outperformers for next year.”

Sectors aside, he urged investors to “keep your duration at or shorter than the index and your coupon at or higher than the index, but you can afford to take your ratings basket below the index,” with a portfolio having a lot of low single-B and high CCC names poised to do well.

What kind of 2015 returns?

Overall, the trader said, “if you’re going to invest in the U.S., you expect the capital markets to continue functioning, and you expect domestic companies not dependent on international sales to do well, then the U.S. high-yield market is still very, very attractive, and I think we’ll still have an average coupon of somewhere between 5% and 6%. So if you’re looking for coupon-like returns next year, you could see them – anywhere in the low- to mid-5s.”

A second trader said his company is looking for “not a stellar return for high yield, but somewhere in the 6¾% to 7% area, as a total return for high yield, which is pretty much the coupon.

“We think default rates are going to pretty much stay steady, somewhere in the 2½% area, so we don’t see any concerns there.”

A third trader took a philosophical tack. “This year, you had some sectors doing poorly, and that kind of dragged it down; next year, you may have some other sectors doing poorly and you have a sector that’s been hurting, maybe it’s helping, I don’t know.”

He said domestic-oriented companies would do well, while those with a big global component to their business would not, given the relative weakness of non-U.S economies, and he predicted a return of somewhere between 3% and 5%.

Yet another trader pegged it at 4% on the nose.

One trader queried proved to be a contrarian, warning that junk would likely see between a 5% and 10% loss in 2015, citing the continued problems in the energy sector – which he likened to one leg of a table “getting chopped off,” in turn causing the rest of the market “to start cheapening up.”

Additionally, he said, the possibility of the Fed starting to push interest rates back up this coming year, combined with retail investors – “Mom and Pop,” as he called them – being spooked when they get their Dec. 31 statements from their mutual funds and see just how much of their formerly relatively safe high-yield stake will have evaporated in the current market downturn, as well as a cutback by larger dealers in sales and trading in the junk space, reducing liquidity – will all make for “an ugly storm approaching.”

Others in the market were not quite so bearish in their forecasts.

Others have more optimism

Van Alstyne of Odeon Capital said that in the past, with quantitative easing in effect, “it felt like you could know, or at least have some degree of confidence that prices weren’t going to really harm you – you could collect your coupon and maybe get some capital appreciation. But going into 2015, I’m not so sure that strategy is going to work anymore – I think you have to be trading a lot more and not be as committed to ideas as you were in the past – constantly re-assessing your assumptions and just having more of a thumb on the pulse of the market to make sure your thesis are correct.”

He predicted that “if you make the coupon, it’s with a lot of volatility. Maybe you make the coupon, maybe you don’t. I think people are going to have to be active traders and active portfolio managers, versus just buying and holding and waiting for the coupon. So I would say the average [return] might be the coupon, potentially – but I think there will be a lot of disparity between different investment strategies this year.”

KDP’s Penniman was hopeful that “as long as we have everyday indications that other global central banks are going to be pumping liquidity, and what that’s doing, I think there’s still going to be a demand for spread and interest rates staying relatively low historically.” With an economy that’s expected to be stronger in 2015 than in 2014, and with low interest rates elsewhere, “I think that bodes well for risky assets in 2015.”

Earlier in the fall, he had originally expected a solid year-end rally – something of an early “January effect” – although that would have the downside of coming at the expense of whatever kind of gain the market would have otherwise notched in 2015. Under that scenario, he said, returns were likely to come in at “somewhat less than the carry trade.”

But as it became apparent that there would be no such year-end rally, Penniman modified his forecast, predicting that the junk market has “the potential to do better than carry next year. So I would say if we can do 5½%, 6½% next year, relative to what other asset classes can do, it’s meager for high-yield standards, but I think relatively speaking, it’s going to be a very strong relative performance.”

As market performance continued to swoon in early-to-mid December, Penniman again tweaked his expectations, saying that “when investors reverse positions, however, we will see the lack of liquidity drive prices back higher, and just as dramatically. Thus, liquidity pressures currently inflicting pain will eventually turn into a buyer’s gain.”

“Carry will continue to be important in a continuing era of low inflation and low interest rates for a longer period of time. I am thus more optimistic about prospects for [2015], and when other credit recovers from the energy sell-off, the potential return for high yield can be well in excess of coupon – not less.”

2015 returns reassessed

Bank of America’s Contopoulos meanwhile said BofA had initially forecast that junk investors would likely see returns between 4% and 5% in 2014, but in January upped that forecast to as high as 7% when it became apparent that interest rates – seen as a drag on market performance – would not rise as much as initially feared. He held to that forecast as late as the end of September, and also thought that there was “a realistic chance” that there could be a year-end rally – but “unfortunately, oil took the market for a ride,” rendering those bullish earlier predictions by Contopoulos and other analysts and strategists obsolete.

Heading into 2015, he said BofA expects no better than a 2% to 3% return for high yield. Bank loans, which underperformed junk bonds this past year, will likely top them in 2015.

He said that certainly the first half of the year will look “pretty bleak,” between anticipated further declines in the energy sector, which would likely lead to rising defaults, as well as investor expectations that the Federal Reserve will at some point start nudging interest rates higher, as has been feared for some time. On top of that, he said, continued market weakness would likely lead to increased cash outflows from high-yield funds by retail investors looking to de-risk their holdings. Along with dealer balance-sheet constraints and a lack of liquidity, the combination of all of these factors “could really mean trouble for the market.

“Then the question will become how much of that underperformance in the first half can you make back after Labor Day, in the second half?

Contopoulos concluded that “things will be pretty bad the first couple of quarters and OK the last couple of quarters – but [just] OK isn’t going to make up for pretty bad.”

© 2015 Prospect News.
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