With credit risk continuing to be subdued, external factors provided the largest influence on the market’s direction during the second quarter. These factors included Treasury rates, geopolitical uncertainty, economic data and the Federal Reserve’s outlook.
In terms of monetary policy, global central banks have continued to be generally accommodative, and Fed Chair Janet Yellen’s recent comments have reaffirmed the Fed’s dovish stance. The Fed, as a whole, has discounted any uptick in the consumer price index and other inflationary yardsticks as minimal and of little concern. This position has aided not only the renewed interest in buying Treasury bonds, but also it has reduced market volatility. Credit markets responded positively to these observations.
Going forward, limited market volatility, low rates and modest growth are three factors that will contribute to our prolonged positive outlook for the high-yield bond market. Fundamentals have not changed materially from the previous quarter, which is encouraging. Credit statistics support the case for investing in high-yield bonds. Balance sheets are solid. Leverage ratios and interest-coverage ratios are near, or better than, levels seen in the past 25 years. Meanwhile, corporate cash levels remain high, and acquisition activity continues. Lower-coupon new issues have produced a lower semi-annual interest expense burden.
Further underpinning our outlook for the high-yield bond market is the unprecedented lack of near-term maturities. From now through the end of 2016, investors are only facing $185 billion of maturities within the total leveraged credit market, which includes both bonds and loans. This equates to only a few months of refinancing at the current new-issue market pace. Also worth consideration: The market scale of more than $1.5 trillion at an average coupon of 7% puts more than $100 billion in distributions into investor hands each year. While the statistics vary depending on the source, we should assume that the majority of this capital is reinvested. Organic demand and the lack of mid- to high-single-digit income alternatives create considerable ongoing demand for high-yield bonds.
Overall, we have a positive outlook on the US economy, as statistics continue to support a slow trend toward higher growth. The Fed’s asset purchases continue to be reduced based on its confidence in the economic trajectory. After each FOMC meeting during the quarter, the Fed announced it would continue cutting purchases of Treasuries and mortgages by an additional $10 billion per month. Going forward, the pace of tapering asset purchases and the eventual tighter stance by the Fed will be data-dependent.
For the rest of 2014, interest rates will continue to be a factor. The direction of rates remains difficult to predict. However, unless there is specific credit deterioration, spreads will continue to tighten. Total market spreads ended the quarter at approximately 350 basis points over comparable Treasuries. This stage of the market cycle, from a statistical perspective, is best compared to the mid-1990s and mid-2000s—market environments that exhibited economic stability, low defaults and ample liquidity. The high-yield bond market has priced in a default-rate forecast that is higher than the current rate. Among fixed-income alternatives, high-yield bonds will continue to be a contributor from both a diversification and a relative-performance perspective.
Looking ahead, nearly all strategists agree that the outlook for credit is positive, with few defaults projected for the remainder of 2014 and 2015. Interest rates have been additive so far this year. Therefore, unless there is a significant move in Treasury rates, a coupon-like return is probable for the second half of 2014.