Gene Neavin, co-manager of the top-rated $753 million Federated High Yield Trust, divides junk bonds into two categories: the 10 percent of the market issued by metals, mining and energy companies, and the 90 percent from everyone else.
While the first group faces serious problems, the second is in surprisingly good shape, according to Neavin, whose fund has the best five-year performance among its peers. His view contrasts with bleaker forecasts from the likes of DoubleLine Capital’s Jeffrey Gundlach.
“The fundamentals are fine, credit quality is fine and defaults will be very, very low,” Neavin, 44, said in a telephone interview from Pittsburgh, where Federated Investors Inc. is based. “We think investors can earn mid to high single-digit returns in high yield this year.”
Junk bonds are mired in their deepest slump since the 2008 financial crisis, hurt by plunging commodity prices and fears that an economic slowdown in China will quash growth in the U.S. The bonds have fallen 8.4 percent since June 30, a Bank of America Merrill Lynch index shows. In the energy sector, speculative-grade debt has lost 33 percent in the same span.
Gundlach, who in early 2015 correctly foresaw tough times coming for high yield, said the bonds may be headed for a steeper selloff.
“We could be looking at a really ugly situation in the first quarter of 2016,” Gundlach told investors during a Jan. 12 webcast. “I’m not yet a buyer.” At a conference in Florida on Jan. 25, he said issuance will probably collapse with yields up and the economy struggling.
Defaults will climb in the U.S. this year and credit-market volatility could increase the chance of a recession, according to New York University finance Professor Edward Altman, developer of the Z-Score method for predicting bankruptcies.
“It is fair to say the likelihood of recession in the U.S. is much higher than just three months ago,” Altman said in a Jan. 25 conference in New York.
Investors have turned away from the asset class, pulling a net $9 billion from high-yield U.S.-based mutual funds in the fourth quarter — the most in more than a year — according to data from Morningstar Inc.
Federated High Yield Trust returned an annualized 5.6 percent over the past five years as of Jan. 29, ranking first among 106 U.S. junk-bond funds with at least $250 million, according to data compiled by Bloomberg. Neavin and co-manager Mark Durbiano are part of a group that oversees $11.5 billion, including the $4.1 billion Federated Institutional High Yield Bond Fund.
The managers look for issuers with stable and predictable cash flow. High Yield Trust typically has less exposure to commodities, including energy, than its benchmark, the Barclays High Yield 2% Issuer-Capped Index, Neavin said. Adding leverage to a company in a volatile business is dangerous, he said, explaining the decision.
While he expects more bankruptcies among commodity companies, Neavin doesn’t think those failures will have much impact on the broad high-yield market. His reasoning: Prices on those bonds have already slumped enough to reflect the coming bad news.
“The damage has been done,” he said. “The pain has been felt.”
Outside of commodities, Neavin sees mostly good news. If the U.S. grows 2 percent to 2.5 percent this year, in line with consensus forecasts, that should be enough for companies to service their obligations, he said.
The rampant pessimism reminds Neavin of 2011, when investors, frightened by the prospect that Europe’s government debt problems would spill into the U.S., sent the Merrill Lynch high-yield index to a loss of 6.3 percent in the third quarter. As concern ebbed, the gauge rallied 19 percent in the next 12 months.
Today’s gloom is most overdone in the pipeline field, said Neavin, where the bonds of oil and natural gas transporters are caught up in the energy selloff even though they have limited exposure to commodity prices. One of his pipeline holdings, a bond from Crestwood Midstream Partners maturing in 2023, is down about 12 percent in 2016.
Neavin doesn’t know when the turnaround for high-yield bonds will happen, but, barring a recession, he is confident that it’s coming.
“When investors feel more comfortable about the U.S. economy and about the risks coming out of China,” he said, “risk assets, including high yield, will rebound.”
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