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Tuesday, June 28, 2016

Brexit: What Does It Mean for U.S. Corporate Credit?

Brexit: What Does It Mean for U.S. Corporate Credit?

Key Points

  • The Brexit decision is likely to affect most types of investments, including U.S. corporate credit.
  • High-yield bonds and preferred securities may be particularly vulnerable to price declines.
  • Investment-grade corporate bonds should continue to make up a fixed income investor’s core portfolio holdings, in our view.
British voters’ decision to leave the European Union—commonly known as the “Brexit”—is likely to affect most types of investments, including U.S. corporate credit. In the hours after the Brexit vote, global investors focused on what they perceived to be the safest investments, and money flowed into U.S. Treasury securities. Performance was mixed for other investments, such as investment-grade corporate bonds, high-yield corporate bonds and preferred securities. Going forward, we think the Brexit decision will lead to more volatility in the fixed income markets, especially for those securities with higher credit risk.

Higher-rated investments performed relatively well on the day after the Brexit vote

Source: Bloomberg and Barclays. Barclays U.S. Treasury Index, Barclays U.S. Corporate Bond Index, Barclays U.S. Corporate High-Yield Bond Index, BofA Merrill Lynch Fixed Rate Preferred Securities Index, and S&P 500 Index. Total returns from market close on 6/23/16 through market close on 6/24/16. Returns assume reinvestment of dividends, interest, and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.

High-yield corporate bonds may be particularly volatile

During periods of heightened market volatility, investors often seek safe-haven investments such as U.S. Treasuries, while high-yield corporate bond prices have tended to suffer.1 High-yield corporate bonds have a higher risk of default than investment-grade corporate bonds—that is, a higher probability that the issuer won’t be able to make scheduled debt payments, and in a worst-case scenario might not even return investors’ principal. Given that higher risk, they tend to perform poorly when economic conditions deteriorate.

The high-yield bond market also tends to have relatively low liquidity, a measure of the ease and price efficiency with which securities can be bought and sold. When investors seek safe havens in times of market stress and try to sell higher-risk investments, low liquidity could lead to large price fluctuations. Historically, the performance of high-yield corporate bonds has tended to be more correlated with U.S. equities than with U.S. Treasuries.2 In other words, when stock markets fall, high-yield bond prices also tend to move down.

Another key risk for high-yield bonds is the market’s exposure to the price of oil. In the past few years, the percentage of bonds in the high-yield market issued by speculative-grade energy and natural resource companies has surged, to the point that energy sector issuers now make up nearly 14% of the Barclays U.S. Corporate High-Yield Bond Index. Lower prices mean less revenue and cash flow to pay creditors, heightening the risk that some companies could default on their debt. At the end of May, the trailing 12-month speculative-grade default rate had risen to 4.1%, compared with just 1.4% two years earlier.3

What does Brexit have to do with oil prices? It could affect two pressure points: the value of the U.S. dollar and the pace of global economic growth. In the two trading days after the June 23 Brexit vote the U.S. dollar rose by more than 3% compared with a broad basket of currencies, while the price of West Texas Intermediate crude oil dropped more than 7%. Most globally traded commodities, including oil, are priced in U.S. dollars. A stronger dollar makes these commodities more expensive for buyers who must convert their currency, even if the actual price of the commodity hasn’t changed, and commodity prices often move lower to offset that rise. Oil prices also tend to be sensitive to the ups and downs of the global economy, so if Brexit results in slower growth, oil prices could decline. While the price of oil had risen from lows reached this past January, stabilizing in the $40-$50 per barrel range during the previous two months, a further rise in the U.S. dollar could push the price lower.

High-yield bond prices have trended with the price of oil

Source: Federal Reserve Bank of St. Louis and Barclays. Crude Oil Prices: West Texas Intermediate – Cushing, Oklahoma and the Barclays U.S. Corporate High-Yield Bond Index. Daily data as of 6/27/16. Past performance is no guarantee of future results.
A credit spread is the difference between the yield on a corporate bond and the yield on a Treasury with a comparable maturity—it can be considered a premium for taking on the additional risk of a corporate bond. Although high-yield credit spreads are near their long-term average, we see risks ahead, including last week’s decision in the U.K. The Brexit decision will likely lead to more volatility and potential price declines, so we think it’s best for investors to stick with their long-term allocations to high-yield bonds, and not reach for yield if it’s not suitable for your risk tolerance.

Investment-grade corporate bonds: check your sectors

Investment-grade corporate bonds performed better than high-yield bonds immediately after the Brexit decision was announced, posting a positive return on June 24. Unlike high-yield bonds, investment-grade corporate bonds are more correlated with Treasuries than with stocks, so stock market volatility and declines doesn’t necessarily have the same effect on higher-rated bonds as on lower-rated ones.

The impact may be more significant in some sectors than others, however. We think the financials sector is one area of the investment-grade corporate bond market that may see more volatility. If the Brexit vote leads to slowdown in global growth, bank profitability often takes a hit because borrowing, from both businesses and consumers, tends to slow down. And many large U.S. banks earn a portion of their revenues from Europe—another potential hit to their profitability.
The Brexit vote has also led lower market expectations for further U.S. interest rate hikes, which can be a hindrance for banks as well. With yields so low, it’s difficult for banks to make much money on their loans. An ongoing near-zero interest rate environment may continue to weigh on bank performance. Overall, U.S. banks are in pretty good shape, however. Regulations put it place since the 2008 financial crisis are meant to keep the balance sheets more stable. Also, the Federal Reserve released on June 23 the first set of results from its most recent bank stress tests—all U.S. banks that were tested passed.

Investment-grade corporate bonds should continue to make up part of a fixed income investor’s core portfolio holdings, along with high-quality investments like Treasuries, in our view. While investment-grade corporate bonds may be more volatile than Treasuries in the short-term, volatility should remain lower than that of high-yield corporate bonds. But check your sectors—bonds issued by financial institutions could be more prone to price declines than those issued by companies in other sectors, such as utilities or industrials.

Preferred securities’ exposure to financial issuers may increase their volatility

Preferred securities could be volatile in the coming months not only because they share characteristics of both stocks and bonds, but because the market is dominated by financial institutions. Financial-institution issuers make up more than 70% of the BofA Merrill Lynch Fixed Rate Preferred Securities Index.

In the two trading days ending on June 27, the S&P 500® Financials Index dropped by more than 8%, compared with a 5.3% decline in the broad S&P 500 Index. The preferreds market tends to move in the same direction as financial stocks, especially during periods of market volatility.

Preferred securities may act more like stocks than bonds during periods of market volatility

Source: Bloomberg. Daily data as of 6/27/16. Past performance is no guarantee of future results.
The average price of the preferred securities index only dropped 0.7% in the two trading days ending on June 27, but earlier this year the index was pulled sharply lower by the drop in financial stocks. And considering the average price of the index is close to its highest level in more than three years, and not much lower than its all-time high, there might be more downside than upside here. The direction of financial stocks will almost certainly spill over into how preferred securities perform in the second half of the year, in our view.

Investors looking for higher income opportunities should still consider preferred securities, but we expect plenty of volatility ahead. For investors with longer time horizons who can stomach large price fluctuations in exchange for the higher yields, preferreds may make sense. But for investors with shorter investment horizons who can’t handle large price swings, we’d recommend a more conservative investment approach and a focus on core fixed income holdings.

What to do now

Don’t reach for yield if you can’t stomach increased volatility. We expect heightened volatility, and potential price declines, in high-yield corporate bonds and preferred securities, meaning there may be better times to invest in the months to come. Investment-grade corporate bonds should be less volatile, and still make sense for investors’ core fixed income holdings, in our view.

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