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.