Spreads have tightened over the last year, and this has propelled investors to ponder their options:
- Stay the course, as the strategic case for high yield remains intact.
- Manage risk within high yield by seeking to reduce duration or lower-grade credit exposures.
- Chart a new course that seeks fixed-income exposures opportunistically.
Spreads Have Tightened
High-yield spreads over Treasurys have tightened this past year amid a growing economy, improving corporate profits, and a rebound in commodity prices (Figure 1). As a result, default rates are starting to slowly taper off, too – a dynamic we expect to continue. Tight spreads in the 1990s and 2000s persisted, as long as the underlying fundamentals held up. While spreads today are above the tightest levels reached in the past, the value proposition is not what it was a year ago, propelling investors to ponder their options.
Figure 1: High-Yield Spreads Have Tightened
Source: Thomson Reuters Datastream, 3/8/17. Last data point, 3/1/17. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. High-Yield Option-Adjusted Spread is represented by Bank of America Merrill Lynch High Yield Master II OAS. The BofA Merrill Lynch Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond’s OAS, weighted by market capitalization. The BofA Merrill Lynch High Yield Master II OAS uses an index of bonds that are below investment grade (those rated BB or below). The Default Rate is represented by Moody’s global speculative-grade default rate (trailing 12 months).
We monitor a range of indicators that have historically served as early warning signs of incipient defaults. They include: (1) corporate profit margins, (2) bank loan delinquencies for commercial and industrial loans, (3) the Federal Reserve’s Senior Loan Officer Opinion Survey data on lending standards, and (4) the Institute for Supply Management’s survey of new orders for businesses. Together, our analysis of these indicators suggests defaults should taper off over the next 6-12 months.
Stay the Course
High-yield bonds are currently yielding 6.2%, far higher than investment-grade bonds, cash, or overseas alternatives (Figure 2). Depending on one’s goals, this could be a powerful consideration.
Figure 2: In a Comparison of Yields, High Yield Stands Tall
Sources: Bloomberg, Thomson Reuters Datastream, 3/8/17. Last data point, 3/7/17. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. Bank Loans is represented by S&P/LSTA Leveraged Loan Index, Short Duration High Yield is represented by BofAML U.S. Cash Pay High Yield BB-B Rated 1-5 Yr Index, High Yield is represented by Bloomberg Barclays U.S. Corporate High-Yield Index, U.S. Investment Grade is represented by Bloomberg Barclays U.S. Corporate Investment-Grade Index, Italian 10-Year is represented by the Italy 10-Year Bond, Spanish 10-Year is represented by the Spain 10-Year Bond, German 10-Year is represented by the Germany 10-Year Bond, and Japanese 10-Year is represented by the Japan 10-Year Bond.
In addition, there is the portfolio efficiency argument. Adding high-yield bonds to an opportunity set of core bonds may make for more efficient fixed-income portfolios at various points along the risk spectrum. That’s because high-yield bonds have different properties than core bonds. High-yield bonds generally have greater credit risk and less interest-rate risk – all else being equal.
In the past 20 calendar years, the income produced by high-yield bonds has helped offset garden-variety price gyrations. In this 20-year period, high-yield bonds have produced positive returns 17 times (85%), positive rolling 10-year compounded returns 100% of the time, and average annualized returns exceeding seven percent.1 Past performance is not a guarantee of future results.
Adding high-yield bonds to an opportunity set of core bonds has the potential to make for more efficient fixed-income portfolios at various points along the risk spectrum.
Managing Risk within High Yield
The high-yield market is one where investment discipline historically paid competitive dividends1. Investing via an active manager with a track record of navigating risky markets, while seeking to avoid defaults and seeking to produce below peer group drawdowns, is a compelling way of improving a portfolio’s return-risk profile in the asset class. Please note that active management strategies typically have higher fees than passive management.
Let’s now explore two tactical paths an investor can take to manage risk within high yield.
Path 1: Reduce Duration
We expect the Fed to continue raising interest rates this year and beyond, and the central bank’s own dot-plot forecasts a term rate of 3% when their multi-year tightening campaign concludes. Floating rate loans and short-duration high-yield strategies seek to reduce a portfolio’s sensitivity to interest rates.
We believe rate increases, plus a growing economy, should exert upward pressure on the yield curve. Floating rate loans and short-duration high-yield bonds (high-yield bonds, too) have outpaced investment-grade bonds during the last four periods in which U.S. 10-year Treasury rates rose by 1.25% or more (Figure 3).
Figure 3: Performance during Previous Rising Rate Periods
Source: Morningstar, 12/31/16. Floating rate loans are represented by the S&P/LSTA Leveraged Loan Index. High-yield bonds are represented by the Bloomberg Barclays U.S. Corporate High-Yield Index. Investment-grade bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Short-duration high-yield bonds are represented by the BoA/ML U.S. Cash Pay High Yield BB-B Rated 1-5 Year Index. An investment cannot be made directly into an index. Past performance is no guarantee of future results. Index definitions can be found at the end of this report.
Path 2: Sidestep the Riskiest Credits
Academic research has historically demonstrated a “low-volatility anomaly”, whereby low-beta assets produce higher risk-adjusted returns than their risky, high-beta peers. Owning bonds has the potential to manage the downside risk, while attempting to avoid giving up too much income, thus potentially improving the risk-adjusted return.
By following decision rules that evaluate the composition of risk individual credits pose to a portfolio, using market signals rather than ratings, which can lag, strategies that veer from the riskiest holdings can potentially reduce the volatility of a high-yield exposure.
Chart a New Course
The level and slope of the yield curve seldom stay still for long. The same can be said for the spreads between different bond market segments, as well for different bonds within a particular segment.
It’s been said “there is always a bull market somewhere.”
Investors who saw the tactical merit in the high-yield bond market when spreads were wider, if suitable, can still seek to harness that opportunistic, spirit now that spreads have narrowed. One option involves a “go anywhere” or unconstrained approach to the bond market. By canvassing the best ideas in a wide opportunity set, an experienced team with deep-research and risk-management capabilities may be in a favorable position to routinely weigh the marketplace’s risks and rewards, as they come into view.
Figure 4: Top-Down Macro Analysis for an Unconstrained Approach
Low interest rates
Wide credit spreads
Fed on hold/tightening
↑ Interest rates
↓ Credit spreads
Fed on hold/loosening
High interest rates,
Narrow credit spreads,
↑ Interest rates
↓ Credit spreads
|Yield Curve||Steepener||Steepener to Flattener||Flattener to Steepener||Steepener|
High-yield bond spreads have tightened over the past year, and this has propelled investors to ponder their options. The right strategy can vary, based upon one’s goals and circumstances. The good news is that a robust opportunity set does exist. Several of the strategies discussed within are actually held in allocation and target date portfolios that members of our team advise for MainStay Investments.
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
1. Source: Bloomberg, MainStay Investments. Data as of 3/15/17, last data point, 3/1/17. Risk return metrics and historical performance are calculated by MainStay Investments, using the Bloomberg Barclays High Yield Index. The calculations use 20 years of monthly returns (1997). Return and standard deviation calculations are annualized averages using monthly, rolling one-year, rolling three-year, rolling five-year, and rolling 10-year returns. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Standard deviation is a measure of the dispersion of a set of data from its mean. If the data points are further from the mean, there is higher deviation within the data set. Standard deviation is calculated as the square root of variance by determining the variation between each data point relative to the mean.
High yield securities (junk bonds) have speculative characteristics and present a greater risk of loss than higher quality debt securities. These securities can also be subject to greater price volatility.
Floating rate funds are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, non-diversification, borrower industry concentration, and limited liquidity.
BofA Merrill Lynch Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond’s OAS, weighted by market capitalization. The BofA Merrill Lynch High Yield Master II OAS uses an index of bonds that are below investment grade (those rated BB or below).
BoA/ML U.S. Cash Pay High Yield BB-B Rated 1-5 Year Index is a subset of the BoA/ML U.S. Cash Pay High Yield Index including all securities with a remaining term to final maturity less than 5 years and rated BB through B inclusive.
Bloomberg Barclays U.S. Corporate High Yield Index measures the market of USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody‘s, Fitch, and S&P is Ba1/BB+/BB+ or below. The index excludes emerging market debt.
Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged market value-weighted performance benchmark for investment-grade or better fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of at least one year.
Bloomberg Barclays US Corporate Investment Grade Index is a market-weighted index that includes publicly issued US corporate and specified foreign debentures and secured notes that meet the maturity, liquidity and quality requirements.
S&P/LSTA Leveraged Loan Index is a broad index designed to reflect the performance of U.S. dollar facilities in the leveraged loan market.
Italy 10 Year Bond – The rates are comprised of Generic Italian government bonds (Gross Yields-before taxes).
Spain 10 Year Bond – The rates are comprised of Generic Spanish government bonds.
Germany 10 Year Bond – The rates are comprised of Generic German government bonds.
Japan 10 Year Bond – The rates are comprised of Generic Japanese government bonds.
MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. The MainStay Funds® are managed by New York Life Investment Management LLC and distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC.