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AllianceBernstein’s $24bn Distenfeld: the truth behind the HY sell-off

AllianceBernstein’s $24bn Distenfeld: the truth behind the HY sell-off

The following comment piece was penned by AllianceBernstein's Gershon Distenfeld, the US firm's high yield director and co-manager on the $24 billion AllianceBernstein Global High Yield fund, and credit fund manager Ivan Rudolph-Shabinsky.

The recent sell-off in high yield bonds has many investors wondering whether this is another big buying opportunity - like prior sell-offs have been - or the start of something more ominous.

As we see it, the decline in high yield bonds was mostly due to technical influences: outflows from retail high yield funds teamed up with record-setting issuance to soften markets. Add in a couple company-specific credit problems…and the high yield market was down more than 2% in September.

Of course, retail flows could continue to exit high yield, pressuring returns. But from our view, most of the selling has been by broker-dealer firms and hedge funds - not long-term investors.

No case for allocation shifts

If longer-term investors start to sell, we could see a more meaningful correction. But issuance is slowing down - a few large issues are still interested but the groundswell of issuance we saw in September is gone.

On the demand side, many retail and institutional investors see 6%-plus yields as a tactical opportunity to top up allocations and invest marginally, but they don’t necessarily view them as the time to make a big move back into high yield. Based on this more favorable supply/demand balance and fairly strong underlying fundamentals, our view is that the weakness is unlikely to continue.

That said, while this may be a tactical investment opportunity for some, we don’t see this as an opportunity for investors to get overly excited and shift assets toward high yield. Yes, overall yields and spreads - or the extra yield versus Treasury bonds - are higher than they were at the start of September, but they remain below long-term averages. And while fundamentals are still relatively strong, we’re in the latter innings of the credit-market cycle and are seeing some deterioration.

There are no great opportunities available and no massive dislocations to capitalize on. That’s why we think that a conservative, diversified approach to high yield makes the most sense.

Stretching for yield can be risky

Our biggest concern: the lowest-rated credits. CCC-rated bonds have recently begun to underperform, but these are the most fragile companies with the most leverage. It doesn’t take much for these companies to fail - they often do so even before the broader market starts to see real deterioration.

Investing in lower-rated credits requires extensive research - and a big expected-return hurdle to make it worthwhile. Since CCC yield spreads don’t compensate investors for average historical credit losses, defaults would have to be well below average over the next five years to make them profitable.

While near-term defaults don’t appear imminent, forecasting defaults beyond the next 18 months is tricky. Betting on a very different outcome than what we’ve seen historically doesn’t seem prudent. Also, returns on CCC bonds will fall long before actual defaults turn up. So, while the lower default rates expected in 2015 provided a great reason to buy CCCs in 2013, they provide far less comfort to us in terms of return expectations over the next 12 months.

Investor power

On balance, the events of September don’t really change the long-term story for high-yield bonds, in our view. The good news is that the power pendulum has swung back to investors. They now have the upper hand in negotiating the yields and terms of new deals with issuers.

In many respects, continued market turmoil may be an investor’s best friend: it extends the credit cycle, making companies more careful and thoughtful with their resources while at the same time increasing expected returns.

We think investors should continue to take a global, multi-sector approach when it comes to high yield - but maintain a cautious outlook in the months ahead.

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