A director at the world's biggest investor breaks down why investors are pouring into one of the riskiest markets
As head of BlackRock's global credit platform, Keenan oversees the flagship BlackRock High Yield Bond Fund.
In our recent interview with Keenan, he said a "regime shift" in the economy is encouraging investors to take on more risk. But that's only likely to become a problem in the next two years or so.
This interview was edited for length and clarity.
Akin Oyedele: There has recently been a surge of inflows into high-yield debt. What do you think is behind this?
Jim Keenan: If you take a step back and think about all the asset classes, where they are priced today, and the economic backdrop, credit is not exciting.
But the backdrop still seems okay. The reasons include we continue to have economic tailwinds. Remember that in 2015, we had an earnings recession where you had the commodity sell-off that flowed into other sectors. You had a pretty big pullback in risk assets and certainly in the credit markets that slowed down a lot of the emerging-market countries. And then mid-2016, you started to see that recover.
That in it's very nature started to create almost like a mini-cycle where you started to see some more positive upside. Fuel got put on the fire with the election at the end of the year. Not that it's been approved or enacted, but you have a government in which the rhetoric behind their policy is one that is pro-US growth and pro-reflation. Even though prices for credit assets might not be that exciting from an absolute return perspective, this environment will tend to be something that produces decent relative returns.
A lot of the high yield and bank-loan assets are still going to be subject to volatility. But if you look over the next 12-18 months, if this policy comes through, you're at a period of time where fixed-income assets and more rate-sensitive assets could be exposed to inflation picking up further, and being very subject to interpretations of both fiscal policy and monetary response to that policy. Your outcome for rate assets could be dramatic with regard to the shape of the curve and the level of inflation.
It's harder to invest in an environment where you still have a very low absolute yield across global fixed income assets or rate assets. You're also at a point in time where there's a lot volatility associated with the timing and success of fiscal policy, which could lead to more volatile drawdowns in the equity market. So you get more upside convexity if all this comes through, but certainly people are starting to question that.
High yield and bank loans tend be tied towards the health of corporate profits. US high yield is tied towards the local companies which benefit from a lot of these policies. Maybe you're going to make a 4-5% return profile off that. In today's world, if you can do that with a higher degree of confidence because of the current economic and policy environment, that's what's leading to people taking money off the shelf and put it in. It's not because there's a high expectation that you're going to see spreads rally. It just becomes attractive viz-a-viz that backdrop.
Oyedele: So based on this macro backdrop, do you think that the premium of high-yield above Treasurys is fairly valued?
Keenan: It's not without risk. I think it's fair right now, but it's full.
What I mean is I think in this backdrop, if successful, the sentiment alone in the market is going to continue to lead - probably over at least the next couple of quarters - a positive momentum with regards to corporate investment and consumption. In all likelihood, there's a pickup from the last couple of years when you were in more volatile times. That generally is a positive economic environment. And I think the Fed will increase rates, but it's still going to be slow because they're still looking at incoming fiscal stimulus and where inflation is going.
High yield, I think, is fair to the level of risk in the economy right now, if you look at it over the next 12 months. If you look at periods of time when there was a positive economic backdrop, spreads can be low for a long time.
Looking at the underlying risks of credit, this is nowhere near the excessive lending and risk profiles and leveraged-buyout activities that went on pre-financial crisis. A lot of rules over the last few years have led to corporate activity that has been far more conservative. Balances sheets are in pretty good places. Certainly, there's a little bit more excessive risk getting put on, but it's not like there's big-time leverage like you saw in 2006/2007.
Oyedele: The president is working to scale back some of those regulations put in place after the financial crisis. What's the possible impact of this, keeping in mind of course that it's still very early days?
Keenan: It's hard to look at what it's going to look like over the next two to four years.
Post-crisis, investors, corporate managers, and certainly the banking system were far more conservative either because they had to be, or because they were more worried about deflation or the potential risk to the downside. You had a long period of time where it was about balance sheet cleansing and healing, and you had fiscal gridlock and excessive monetary policy. Those had limitations and you didn't necessarily see the flow through down into the real economy.
This is a regime shift. You are shifting from a fiscal gridlock and monetary stimulus to monetary data dependency and fiscal stimulus. So there is a shift here to try to drive economic activity directly into the real economy. How that plays out remains to be seen over the long term. But in the short term, it's certainly a bit more positive.
In past environments when you had very strong economic growth, you generally had investors that tried to create excess returns that stretched into areas which are fine in a growing environment. But if there start to be shifts, that's when you start to see people taking on too much risk relative to the level of returns. I don't see that as a problem right now in 2017. In 2018 or 2019, there's certainly a level of cyclicality that's brought back into the market because these policies are stimulating above-trend growth. And the higher or the longer you drive this, in all likelihood, that shapes when you start to see that correction come in.
Oyedele: What sectors do you like and dislike right now?
Keenan: We're probably a little bit more conservative in the short-term and dialing back risk because since November, you've had a pretty big run up in risk.
That being said, over the next six months, there's a positive backdrop. But I think you're going to see more volatility spikes, and normalization of some of the corrections that the markets have seen historically. Longer term, I still think that if you do see that correction, it will be a good time to buy in because we still like the fundamental backdrop for earnings and therefore equities and high yield.
We're at a point where we would continue to see steepening of the yield curve and inflation in not necessarily the short term but over the next 12 months as you start to see any of these [Trump] policies get enacted. In that case, things like financials, even though they've rallied significantly, have a pretty decent backdrop.
There's a tailwind behind some of the commodity trades that have gone up. You have to be selective and careful because things have rallied so much. The ancillary part to that is, as you have a more stable oil price and you have a positive economic environment, some of the things around commodities and the derivatives of commodities that took pretty big hits in 2015 have rallied, but there are still ways you can create alpha in that space.
I'd be more cautious of some of the other areas that are far more exposed to secular shifts in the credit markets. Things like retail, brick and mortar stores - the high level of inventories relative to the trend, and Amazon and other online distribution - those are hard businesses to have leverage on right now.