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The election of Donald Trump as U.S. president awakened a speculative frenzy for risk assets. Spreads hit multi-decade lows in both high yield and investment grade markets. The HFRI Credit Index returned 1.8% in November, bringing year-to-date returns to 10.1%.
The riskiest segments of the high yield market performed the best in November, continuing a trend that started in July. This is consistent with a trend we have seen in equities where capital has rotated out of large caps and into the Russell 2000.
We suspect that the current reach for yield likely has limited room to run, given absolute valuations are approaching levels that will likely be difficult to sustain. While there are individual companies that are positioned to do well going forward, the return from the Russell 2000 over the past year has been driven by multiple expansion rather than earnings growth.
Equity values matter a lot to the riskier segments of the high yield universe. Higher multiples can effectively bail out overleveraged issuers if management teams and boards make smart tactical decisions about raising capital when market windows open.
In an expensive market driven by sentiment and technical factors we focused on finding individual mispriced securities and participating in well-priced new issues. In liquid U.S. high yield, the value is the worst I have seen in my career; last month BB spreads hit a low of 157 bp Govt OAS, which is the lowest value since 1997. That same year, the average yield on the 5-year Treasury bond was over 6%, so all-in yields are materially lower now than they were then.
We are not expecting any material increase in volatility until early 2025. There are many market participants like hedge fund “pods” whose timeframes are driven by calendar year ends. As the calendar rolls over into a new year this causes traders’ time frames to extend out 12 months. We saw this phenomenon play out in January 2022 when on the first trading day of the year the U.S. Treasury market sold off significantly on no news.
We would not be surprised if credit was a target of short sellers early in 2025 given the historically expensive valuations. It would not take a major event to cause high yield spreads to move 100-150 basis points wider from current levels at some point next year. We suspect that macro products like CDX or ETFs would likely be preferred vehicles to express bearish views on credit.
Justin Jacobsen, CFA, is the Portfolio Manager of the Pender Alternative Absolute Return Fund. PenderFund Capital Management. Excerpted from the Pender Alternative Absolute Return Fund Manager’s Commentary, November 2024. Used with permission.
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