I'm a sucker for action movies, and one of my favorites is “Cliffhanger.”In this 1993 film, Sylvester Stallone plays a hotshot mountain climber who gets caught up in a heist gone wrong as a US Treasury plane along with some bad guys crashes into the mountain on which he’s climbing. The movie’s tag line is “hang on.”

That would be an appropriate tag line for this summer’s high yield market, which has suffered as oil has moved to new lows and fears of a global slowdown have sapped investors’ appetite for risk. The Citi High Yield Market Index now trades at 93.8, the lowest dollar price we have seen since the summer of 2011, and spreads haven’t been this wide since the summer of 2012. Some investors are drawing analogies to the telecom-led high yield market decline in 2001 or the homebuilders-led sell-off of 2006-2007.

NEGATIVE FUND FLOWS

What’s more, investors are also pulling money out of high yield funds. Fund-flow data from EPFR Global shows negative net outflows this year, and the biggest outflow of the year occurred in late July. In other words, sentiment is poor. So where do we go from here? Should investors sell before things get worse, or should they buy because the market has gotten cheaper, or should they just hang on?

We believe now is not the time to sell as the market has sold off just a bit too much. Adam Richmond, Morgan Stanley & Co.’s leveraged finance strategist, notes we may be looking again at what occurred earlier this year when oil started to find a bottom in late January. Even though oil didn’t rally much, the stabilization was enough to drive decent high yield market performance. The Citi index logged a 4.2% return by mid May.

DEFAULT CYCLE

Barring a miraculous rebound in energy and broader commodity prices, the energy and metals/mining sectors will likely lead the next default cycle (see chart). However, we believe the broader market has been dragged down more than it should have been because the economy likely has at least a few years left until the next recession.

To be sure, what’s ailing the market is not just oil; the macro backdrop also needs to improve. China must find its footing, and the Federal Reserve needs to be clearer about its rate hike plans. Their fuzzy intentions and late-summer liquidity, or lack thereof also aren’t helping things. Yet, with sentiment pretty poor and positioning light, we believe the market is setting up for a rebound in coming months if these macro issues begin to resolve.

EARNINGS REBOUND

Within the US we see a rebound in earnings in the next 12 months.We also see a growth rebound as the mix of low interest rates, low oil prices, improving wages and strong household finances works its way to consumer spending. These should boost risk appetite, and we believe high yield will be a primary beneficiary. While we believe a broad rally in high yield is the most likely scenario, investors that want to limit their energy exposure should focus on investment vehicles that have a belowbenchmark allocation to energy—now about 15%. Or, another way to take a more cautious approach is to buy shorterduration high yield securities, which limit interest rate risk. Hang on.



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