Managing risks in the high yield market

by: , Director of Research, IndexIQ

With below investment grade corporate bond issuance at nearly high record levels, short term interest rates on the rise and credit spreads below their long term average, it’s an appropriate time to take a closer look at potential risks in the high yield marketplace. Against this backdrop, we recently sat down with the IndexIQ Team to discuss their current views on the high yield market and where they see potential headwinds and opportunities.

Warning signs for lower rated bonds

While the U.S. economy continues to expand, there are potential headwinds on the horizon. Whether it is steel and aluminum tariffs or more general geo-political tensions, the rosy macro-economic outlook is not without its clouds. At the same time, the Federal Reserve is expected to again raise rates at its meeting in June, which could put a strain on the lengthy economic expansion. Even though expectations for a recession remain muted, signs of a slowdown could pressure credit spreads—especially for lower-rated, high-yield issuers.

Weakening fundamentals

After several years of generally solid high yield fundamentals, there appear to be some cracks in the armor. According to Moody’s, since 2009 the supply of nonfinancial companies rated as speculative has increased 58%, reaching a record high. And while high yield defaults are lower than their historical average, they’ve edged higher over the first five months of the year.

Credit market fundamentals

Source: Federal Reserve and BAML, as of 3/31/2018. Past performance is not a guarantee of future results.

Meanwhile, high yield spreads are relatively low. This is particularly true for CCC and below rated credit versus relatively higher rated BB securities. As such, lower-rated credits may not adequately compensate investors for the potential of an uptick in defaults. And when defaults increase, lower quality credits tend to sell off more than their higher quality counterparts.

Less attractive valuations

Spread difference between CCC and lower and BB

Source: BAML, as of 3/31/2018. Past performance is not a guarantee of future results.

Strategies to manage risks in the high yield market

To be sure, there are challenges facing the high yield market. That being said, high yield bonds have continued to offer relatively attractive yields. And attempting to time the market rarely works. So how can income-seeking investors try to manage the risks and capture the potential rewards offered by lower rated bonds? As shown in the chart below, higher quality high yield bonds (as represented by low MCR high yield bonds) have historically generated competitive yields while also managing risk, more so than many other types of income-producing investments. MCR (“Marginal Contribution to Risk”) is a market based measure that uses the spread and duration of a high yield bond to determine its credit risk relative to the broad high yield market. Reviewing rating changes between BB and B bonds over the past 20 year period shows that MCR is a more timely indicator for credit risk than credit ratings themselves.

Higher quality high yield bonds have presented an attractive risk/reward profile

Source: BAML, Bloomberg, IndexIQ 12/31/2007-3/31/2018. Past performance is not a guarantee of future results.

MCR offers a transparent and objective approach to measure credit risk. It could be used to construct of portfolio of lower risk high yield bonds that allows investors to stay invested in the high yield market while also managing risk.

Conclusions

While high yield bonds have continued to offer relatively attractive yields, fundamentals may have peaked. At the same time, warning signs of moderating economic growth and continued Federal Reserve rate hikes may produce additional headwinds for the asset class. Rather than attempting to time the market and abandon the asset class entirely, a better approach may be to move up the quality ladder. How to identify quality bonds? The high yield bond market could react to credit stress more quickly than the ratings can react. An investment strategy that utilizes market information to select good quality bonds might be a good choice when it comes to investment in high yield ETFs.

About Risk:

All investments are subject to 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. U.S. Treasury Bonds 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.

BBB Rating and higher are considered to be “secure,” and those of ‘BB+’ and lower are considered to be “vulnerable.”

CCC Rating is considered very weak, and a substantial credit risk where default is a real possibility.

Marginal Contribution to Risk (MCR) is a market based measure that uses the spread and duration of a high yield bond to determine its credit risk relative to the broad high yield market.

Maximum drawdown is the maximum loss from a peak to a trough of a portfolio, before a new peak is attained.

Spread is the difference between the bid and the ask price of a security or asset.

New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, New York, New York 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, and NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Kelly Ye, CFA

Director of Research, IndexIQ

Kelly Ye, CFA, is Director of Research at IndexIQ, a wholly-owned subsidiary of New York Life Investments. She oversees new product development across the IndexIQ ETF family. Before joining IndexIQ, Kelly was head of Quantitative Investment Strategy in New York Life Investments

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