The Good (And Bad) News About One Fixed Income Sector

Fortune Cookie

The recent rebound in commodity prices has been good news for high yield bonds, helping the sector (and credit overall) rally since mid-February.

Now the bad news: A slower pace of appreciation is likely from here. Future high yield bond returns will likely be more muted—and depend more on improving fundamentals than commodity prices. This is evident in this week’s chart.

The chart shows how sharply rising commodity prices since February have translated into steeply falling high yield commodity sector spreads. The energy and materials sectors have disproportionately contributed to U.S. high yield performance overall. These sectors account for nearly half of high yield’s total return since the mid-February lows, though they represent less than 20 percent of the market, our analysis shows.

High Yield Spreads

There are some signs that this trend may not last. The People’s Bank of China (PBoC) helped spark the rally in commodity prices earlier this year. PBoC intervention halted fears of a destabilizing Chinese currency devaluation, and sparked hopes of a credit-fueled manufacturing and construction rebound. Recovering housing starts already point to a Chinese real estate recovery. A weaker U.S. dollar also helped commodity prices.

But price increases in some commodities have outpaced fundamental improvements in the supply-demand balance, according to our analysis. Sentiment has rebounded from extreme pessimism—and short positions look less crowded, our research shows. Speculation on Chinese commodity futures exchanges contributed to recent gains—but trading volumes have peaked since authorities raised collateral requirements.

We need to see improved supply-demand fundamentals for a sustained broad commodity rally, and the evidence of that so far is mixed. This means that high yield returns going forward will depend less on the commodities sector and more on evidence of broadening economic growth. A low growth outlook and the recent narrowing of spreads imply that we are likely to see more muted returns going forward. Read more market insights in my weekly commentary.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.


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