High Yield.During the first six weeks of the year, high yield spreads widened by nearly 200 basis points, reflecting expectations of a default environment typically only experienced during recessions. However, spreads narrowed and ended the quarter only modestly wider than year-end levels as more encouraging economic data, rising commodity prices, and further stimulus from global central banks stimulated investor appetite for riskier yield opportunities.
We expect default levels to rise but not materially above long-term averages, with the majority of defaults confined to commodityrelated sectors where low security prices already reflect default expectations. While we believe that we are in the late stages of the credit cycle, defaults are currently dominated by issuers that have survived for longer than they otherwise would due to an accommodative lending environment and less restrictive covenants.
Compared to the start of the year, we believe security selection will become even more paramount to outperformance in the months to come. Consequently, we are strictly adhering to our risk management discipline as we progress through this debt cycle. While lower-quality high yield has outperformed in the recent retracement, we believe higher-quality high-yield issuers that can generate stable financial results even in a slowing global economy provide the better potential from a risk/reward standpoint. We maintain a particular focus on identifying “rising star” candidates ahead of ratings agencies. (Rising stars are issuers that are upgraded to investmentgrade status.) Historically, these upgrades have generated significant spread compression and alpha generation. From a sector perspective, we have a more constructive outlook for consumer goods, select auto suppliers, and outpatient health care, remaining more cautious about financials, lower quality energy, and media.
Convertibles.During the first quarter, convertible new issuance was $16 billion globally. Europe led with $8 billion, while the U.S. contributed $3 billion. So far, issuance has been below historical trend lines, which is understandable given market volatility. New issuance should pick up as cyclical sectors continue to shore-up balance sheets, growth firms seek capital for expansion under more certainty, and stock buybacks continue.
In a volatile environment where the valuations of many defensive stocks are high, we see pronounced opportunities for convertibles as a means to pursue lower-volatility equity participation. We remain focused on the more balanced structures within the convertible market, which we believe enables us to protect on a downside equity move, yet participate in the upside of a volatile market. We are also favoring higher credit qualities. In this lowgrowth environment we’re experiencing, companies with strong balance sheets that generate above-average organic growth have typically been rewarded by investors.
Similar to our positioning in U.S. equities, our convertible positioning reflects our overall emphasis on growth sectors such as information technology and consumer discretionary. We are becoming even more selective in health care, although we have identified potential beneficiaries of long-term secular themes. Although we’ve been quite cautious on energy, materials and industrials, we’ve opportunistically added at the margin when we’ve found attractive valuations and improving fundamentals.
Conclusion.As we have observed throughout the years, short-term volatility in the markets creates long-term opportunities for disciplined investors. While staying highly cognizant of how the market is responding and the implications to portfolios, we are maintaining a research-driven approach and will not rush to follow the herd. Having invested through multiple market cycles, we are confident that we can respond thoughtfully as opportunities emerge and identify a breadth of opportunities—across asset classes and geographies—even in an environment of slow economic growth, where uncertainties are formidable and spates of volatility are likely to continue.