Will High Yield Live Up to its Name (Again)?

by: , Chief Investment Officer and Managing Director | IndexIQ

Once upon a time, high yield bonds were just that: fixed income instruments with substantial yields, often in double digits, generally well above what was on offer from the 10-year Treasury. Like so many other things, that changed during the financial crisis. Yields fell across the board, and spreads – the difference in yield relative to 10-year treasuries – were dramatically compressed, hitting just over 3% early this year. To put that in context, since 2000, the high yield to Treasurys spread has averaged nearly 6%, according to Bloomberg.1

High Yield Spread and Default Rates

*Weighted avg., 12-month trailing. Sources: Thomson Reuters, Bank of America/Merrill Lynch, Moody’s, 12/31/17. The default rate measures the percentage of issuers in a given asset class that failed to make scheduled interest or principal payments in the prior 12 months. The default rate can also be par-weighted, meaning that it measures the dollar value of defaults (based on par value of issued securities) as a percentage of the overall market. The spread to worst measures the difference from the worst performing security to the best, and can be seen as a measure of dispersion of returns within a given market or between markets.

Unlike Treasurys, pricing on high yield is driven not just by interest rates, but also by credit and the likelihood that an issuer might default. All of these factors put investors in a bind – to get higher yields, they had to either extend the duration of their portfolio (buy bonds coming due further out in the future) or invest in the bonds of lower-rated companies more prone to default. But even here, there was increasing concern that investors were not being paid for taking on added risk (as reflected in the tightening spreads).

More recently, rates have been backing up, with the 10-year Treasury hitting 2.9%, the highest level since 2013. High yield bond ETFs saw outflows in that same period. So, what did that mean for spreads? To date, not much. High yield bond prices have also declined, but spreads have been relatively stable. This isn’t too surprising. In fact, high yield often performs well in times of rising rates, as long as the rate increases are driven by stronger economic activity. That economic growth makes it easier for companies to earn a return on capital and to pay down debt.

As with other asset classes, it seems likely that high yield will experience greater volatility going forward. While there’s a new chairman of the Federal Reserve, the policy approach set by Janet Yellen is expected to remain relatively unchanged, i.e., more planned rate increases and the continued unwinding of the Fed’s balance sheet. To the extent this pushes up rates, high yield is likely to follow.

Of course, rising yields are not quite an unalloyed blessing (since prices move inversely). Low volatility funds – which capture most of the upside with lower downside risk. Reinvesting interest income – which in a period of declining prices is put back to work at higher yields – is always a good strategy. Spreads bear watching, too, since it’s where any emerging credit concerns are likely to be seen first. The bottom line is that while high yield is a long way from the double-digit yields of the past, it continues to offer an income opportunity for those who are comfortable taking some risk.

1. Sources: Bloomberg, IndexIQ, 2018.

About Risk:

All investments are subject to market risk and will fluctuate in value. Past performance is not indicative of future results. An investment cannot be made in an index. Alternative investments are speculative, entail substantial risk, and are not suitable for all clients. Alternative investments are intended for experienced and sophisticated investors who are willing to bear the high economic risks of the investment. Investments in absolute return strategies are not intended to outperform stocks and bonds during strong market rallies. Hedge funds and hedge fund of funds can be highly volatile, carry substantial fees, and involve complex tax structures. Investments in these types of funds involve a high degree of risk, including loss of entire capital. Treasurys are backed by the full faith and credit of the federal government, as to the timely payment of principal and interest.

High yield securities generally offer a higher current yield than the yield available from higher grade issues, but typically involve greater risk. Securities rated below investment grade are commonly referred to as “junk bonds.”

Funds that invest in bonds are subject to interest rate risk and can lose principal value when interest rates rise. Interest rates in the United States are near historic lows, which may increase the Fund’s exposure to risks associated with rising interest rates. Bonds are also subject to credit risk, which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner.

Neither New York Life Investment Management LLC, its affiliates, nor its representatives provide tax, legal, or accounting advice. Please contact your own professionals.

The information and opinions contained herein are for general information use only. IndexIQ does not guarantee their accuracy or completeness, nor does IndexIQ 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 as of the date of this report and are subject to change without notice. Past performance is no guarantee of future results.

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. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, New Jersey 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Salvatore J. Bruno

Chief Investment Officer and Managing Director | IndexIQ

Sal is Chief Investment Officer at IndexIQ, where his primary responsibility includes developing and maintaining the firm’s investment strategies. Sal joined IndexIQ in 2007 from Deutsche Asset Management (DeAM) where he held a number of senior positions

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