2019 was a very good year for investors. Surprisingly, both offensive and defensive sectors did well, which is a marked about-face compared with 2018. We believe this is mostly due to a central bank shift to policy easing, especially in the U.S., coupled with a relatively steady economy. The excess liquidity created by the Federal Reserve’s (Fed’s) easier monetary stance did not find its way into increased capital investment but rather seeped into asset prices, lifting many to record highs. Interestingly, in U.S. high yield (HY), there seemed to be a flight to quality, as BBs performed best, while in U.S. investment grade (IG) there was a reach for yield, with the BBBs gaining the most ground.
It was not long ago that worry about the bubble-like expansion in the size of the BBB sector and a possible rise in defaults wreaking havoc on the high yield market were the prevalent views. John Sheehan from our IG team published a rebuttal to those fears earlier last year, and market worry about the BBBs has since receded. The question now is what strategies make sense for investors today? Do we continue to ride the liquidity fueled rise in asset prices, hoping to correctly time a graceful exit, or should we assume a more defensive stance and wait for a more propitious re-entry point?
The U.S. High Yield Index1 returned over 14%, while the investment grade U.S. Corporate & Government Index returned nearly 10%. This is highly unusual as rates generally fall when the economy is weakening and bond spreads are widening. Yields fell last year while spreads tightened meaningfully. Digging a bit deeper we find that the best performers, as mentioned above, were the BBB and BB sectors. The BBB U.S. Corporate Index started the year at 4.69% yield-to-worst (YTW) and tightened 150 basis points (bps) to 3.19% YTW by year end. The BB U.S. High Yield Index tightened by 240 bps from 6.25% to 3.85% YTW. The spread between the two is now very thin, meaning that either BBBs have more to rally or BBs are at risk of pulling back (or both). In any event, we do not expect further tightening of spreads like we saw in 2019, and since we are starting 2020 with lower nominal yields, that portion of returns will be lower. The latest round of Fed easing seemed to be an “insurance” policy aimed at preventing the economy from dipping into recession, rather than the more typical injection of liquidity following the bursting of some asset bubble, as in 2000 and 2008. We can argue that it may not yet have been necessary, but the fact remains that they have used up some valuable ammo that will be needed when recessionary forces do return.