High yield: Spreads tighten, but opportunities endure

Written by: Global Thought Leadership | February 17, 2017
image not found

Source: Bloomberg, as of 2/15/17. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The Bottom Line

  • Sentiment in the high yield bond market flipped from pessimism to optimism over the past year as the sector significantly outperformed other fixed-income groups.
  • A year ago, on February 11, the 12-month total return of the Bloomberg Barclays US High Yield Bond Index was -10.9%—reflecting worries about China, Europe, US monetary policy and global economic growth.1
  • Fast forward to the present: the index was up +25.5% for the 12-months ended February 15, 2017—so, the concerns of a year ago are clearly gone.
  • But is there room for more appreciation? Replicating the barn-burning performance of the past 12 months would be next to impossible, given that the index yield-to-worst is now 5.73% (vs. 10.1% at the market bottom a year ago).
  • The yield advantage relative to Treasuries is lower today as well. The option-adjusted spread has tightened over 470 basis points (bps) to 367 bps from 839 bps over that same period.
  • Yet investors seeking attractive income opportunities shouldn’t turn their backs on the sector—since a positive fundamental and technical backdrop arguably remains in place.
  • From a macroeconomic perspective the asset class has a history of doing well in a slow-growth, low-inflation environment and there’s little on the horizon yet to suggest that’s going to dramatically change anytime soon.
  • Fundamentals for the asset class look supportive, too. The outlook for corporate earnings has improved—and if corporate tax reform is successfully implemented this year, then corporate cash flow could get a further boost. That would improve balance sheet health and could even lead to ratings upgrades.
  • That could improve the general outlook for defaults, which have increased recently. However, much of the increase has been driven by energy and the metals and mining industries. In fact, if you remove those subsectors, the default rate was a mere 0.80% in January, according to J.P. Morgan.
  • The technical environment also appears positive for the sector. Investor demand for high yield bonds was solid in 2016 and early 2017 and the sector is not being pressured by a lot of new issuance either—that can sometimes undermine prices if supply outpaces demand. In fact, net new issuance of high-yield bonds has been negative for nine straight months, according to Western Asset Management.
  • Of course, with yields lower and spreads tighter, investors should certainly adjust their expectations for future performance, keeping in mind that security selection and sector rotation are even more critical when a market is fairly priced—and those are characteristics of actively managed solutions that are not available in passive options. 

 


1 Sources for all data are Bloomberg or Western Asset.

Top

IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.

Outperformance does not imply positive results.

Yields and dividends represent past performance and there is no guarantee they will continue to be paid.

Active management does not ensure gains or protect against market declines.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.