Even as oil prices decline, default rates should remain low for most of the high-yield market, says Tom O'Reilly of Silver-rated Neuberger Berman High Income Bond Fund.
Sumit Desai: Hi, I'm Sumit Desai, fixed-income analyst in Morningstar's manager research group. Joining me today is Tom O'Reilly, co-portfolio manager of the Neuberger Berman High Income Fund (NHIAX). His team also manages the Short Duration High Income Fund (NHSAX) and the closed-end Neuberger Berman High Yield Strategies (NHS).
Tom, thank you for joining me today.
Tom O'Reilly: Thank you.
Desai: Tom, it's been an interesting couple of months within the high-yield market. The energy sector makes up a little bit under 15% of the benchmark that you follow, so oil prices can have a major impact on your sector. Can you talk a little bit about what you've been seeing within the high-yield market over the past couple of months?
O'Reilly: Sure. Just to break down the energy sector a little bit more: Although it's 15% of the high-yield benchmark, 5 percentage points is in pipelines. And so these are higher-quality companies [where] it's more of a distribution than a commodity type of credit. So, we don't see a large impact to that part of the market. Still, if you look at the other 10%, it is a large part of the market; but within that 10%, [that is mostly composed of] higher-quality E&P companies. There are some CCCs that are about 1%, which are the lower-quality names. And there's also around 2% in service companies, which we also do see as higher-risk types of credits. But the majority of the energy space within high yield is higher quality.
Desai: So, clearly with oil prices declining, it's caused some of these bonds to sell off. What impact has the energy sell-off had across the rest of the high-yield market? Have you seen any kind of impact there?
O'Reilly: Sure. If you look at valuations in the market now, high yield versus energy, energy is trading at the widest valuation that it's ever traded relative to high yield. In terms of yields, energy is around a 10% yield and high yield is around a 7% yield. Over the last few weeks, we have seen a spill-over into other high yield, primarily as we've seen outflows in the space; that has created widening across all high yield. That being said, the last few days, we've seen a lot of strength as we think the market has been oversold and started reaching yields almost close to 8% on the overall benchmark, and that drove more money back into the market itself.
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Desai: You mentioned outflows. One of the concerns within the high-yield market is also liquidity. Have you seen any kind of liquidity impact as a result of energy prices declining?
O'Reilly: Certainly, liquidity gets a lot of headlines, and the dealers have been out of the high-yield market now for about four or five years. Their inventory levels relative to the size of the high-yield market, at around $2 billion versus a $1.5 trillion market, are non-existent in our opinion. And a lot of the trading that does get done, day to day, is customer to customer. We look at liquidity on the volume that gets traded every day, and if you look at trace volumes, the market is still trading around $10 billion to $12 billion a day.
So, we think liquidity in the market has not changed. Certainly, the volatility of prices is higher than it's been in the past; but we still think you can execute within the market the same today as you have been able to in the past.
Desai: From a bottom-up perspective, obviously forecasting oil prices plays a major role in your investment decisions. How do you go about forecasting where oil would be in a period when it is so volatile?
O'Reilly: We look at these prices longer term. We think there is going to be volatility and certainly downside to prices in the spot market today. But we look at marginal cost over the longer term of all global energy companies, and we think oil really needs to gets back, longer term, to around $80 a barrel. We certainly don't think that happens in the short term; but we think, over the next year or two, marginal costs are around $80, and we think that's where oil will eventually settle in at.
Desai: Given the sell-off over the past couple of months and what really up until the past couple of days has been a pretty rough December for the high-yield market, do you view this as a buying opportunity for high-yield bonds or do you think there might be another leg down that investors should wait for?
O'Reilly: We look at valuations versus fundamentals. And fundamentals in the market, generally, are still very good. In the past few years, we've seen very low default rates of 1% to 2%. Might default rates move up 2% to 3% over the next few years? Possibly. But that's still below long-term averages. And if you look at yields and spreads in the market, we think they're very attractive. We've seen a lot of flows come back into the high-yield market. Every time our yield goes to around 7% or 8%, spreads of around plus 600, we think that's an attractive entry point. While energy is, we'll call it, 10% of the high-yield market, the other 90% is still, in our opinion, fundamentally very strong. And lower oil prices also have positive impacts on other sectors.
So, as we look for the next few years in high yield, we think fundamentals will remain good--meaning that default rates remain relatively low. And we think you're getting paid for that lower default risk in the high-yield market with valuations that we think are very attractive.
Desai: The Neuberger Berman High Income Fund, at the end of November, had about 19% of assets invested in energy high-yield bonds. Can you talk a little bit--or as much as you can--about how you've adjusted that positioning and where you've been maybe adding or taking away some exposure?
O'Reilly: Again, as I mentioned before, about how energy is classified: If you look at our underlying portfolio, we're focused on more high-quality companies, whether it's in pipelines, which we don't think have a large credit impact from these lower prices, or within the E&P space--we're in higher-quality BBs. And in the Bs that we own, we're in basins that we think are strategic to larger-cap types of credits where there could be M&A that would benefit us. We have avoided oil services. We've avoided CCC issuers. So, when we look at our portfolio and we do a downside analysis, we've run the price deck of oil at $50 a barrel for the next three years. We don't think we have any default risk in our own portfolio.
Desai: Tom, thank you very much for joining me today.
O'Reilly: Great. Thank you.
