Income investing as credit spreads widen and the yield curve flattens
It has been a challenging year for investors, particularly those looking to fixed income for the purposes of generating income, diversifying an equity portfolio, or reducing overall risk. In addition to trade war and tariff rhetoric, interest rate policy has been one of the most significant drivers of financial market price movements and investor sentiment. Fixed income overall struggled for much of the year with a couple of exceptions, namely short duration below investment grade asset classes. While bank loans led the way for most of the year, it gave back a good portion of its returns in the fourth quarter, most notably losing 175 bps month to date as of December 19. Even so, bank loans are still outperforming core bonds, investment grade corporates and high yield this year. The asset class that managed to surpass bank loans this year is short duration high yield bonds.
Figure 1: Short Duration HY is leading performer YTD as bank loans struggles in December
Source: Morningstar as of 12/19/2018. High Yield Corporate Bonds are represented by the ICE BofAML US High Yield Constrained Index. Short Duration High Yield Bonds are represented by the ICE BofAML 1-5 Y BB-B Cash Pay HY Index. Past performance is no guarantee of future results, which will vary.
Equity market volatility increased sharply earlier in the quarter and fixed income also got caught up in the risk-off sentiment. Following Federal Reserve statements showing that policymakers are considering a slowdown in rate hikes, it seemed that the narrative shifted from rising rates to the yield curve inversion of the 2 year – 5 year range. However, is important to note that the 2s10s spread did not go negative, but it has decreased significantly indicating a flatter yield curve. Coinciding with the flattening of the yield curve, high yield spreads widened by 100 bps, from 328 to 429 between the end of September and the end of November. Using January 31st as a starting point, short duration HY outperformed the S&P 500 and the Bloomberg Barclays US Aggregate through November 30th amid yield curve flattening and high yield spread widening as shown in figure 2.
Figure 2: Short Duration High Yield Amid Curve Flattening and Spread Widening
Source: Morningstar, ICE indexes, 12/1/2018 Federal Reserve Bank of St. Louis, 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity [T10Y2YM], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T10Y2YM, December 11, 2018. Index definitions can be found at the end of this blog post. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
In figure 3, we take a look at how short duration high yield performed versus the broad high yield market when spreads widened. In “Short Duration High Yield: A flower in the Junkyard” we characterize short duration high yield as having a shorter duration and quality bias compared with the overall high yield market which results in a lower beta version of high yield with less volatility. The chart shows that in the 3-month periods beginning in January and September of this year, high yield spreads widened significantly, but the short duration segment of the market held up fairly well. To be clear, the asset class declined in value over those periods, but to much less of a degree than the market. This demonstrates the more defensive nature of short duration high yield with respect to the overall asset class.
Figure 3: Short Duration High Yield Held Up When Spreads Widened
Source: Morningstar, ICE Indices 11/30/2018. Index definitions can be found at the end of this blog post. High Yield Corporate Bonds are represented by the ICE BofAML US High Yield Constrained Index. Short Duration High Yield Bonds are represented by the ICE BofAML 1-5 Y BB-B Cash Pay HY Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Despite credit spread widening, fundamentals remain strong in the high yield market. New issuance is dominated by BB-rated bonds and the market, as represented by the ICE BofAML US High Yield Index, is comprised of only 12% CCCs, as compared with 32% at the end of 2008. Issuer leverage has not increased and in fact has recently declined, while the default rate is 1.9%, markedly below the 20 year average of 3.2%. With wider spreads and a higher yield to maturity, high yield valuations suggest a more attractive entry point for investors. Regarding short duration high yield specifically, it is an interesting investment solution because it solves for many different problems. In addition to providing income, it may serve as a way for investors to diversify a core bond portfolio, de-risk a high yield portfolio, or reduce a bank loan position. It also may make sense for investors looking to reduce equity exposure. As volatility continues to be an important topic of conversation between investors and their advisors, short duration high yield may deserve consideration for inclusion in investment portfolios.
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner, or that negative perception of the issuer’s ability to make such payments may cause the price of that bond to decline. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
Basis points (BPS) refer to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
High-yield securities carry higher risks, and some of the Fund’s investments 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.
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.
ICE BofAML US High Yield Index – The index tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
The ICE BofAML BB-B U.S. High Yield Constrained Index contains all securities in the ICE BofAML U.S. High Yield Index rated BB+ through B- by S&P (or equivalent as rated by Moody’s or Fitch), but caps issuer exposure at 2%. Index constituents are capitalization-weighted, based on their current amount outstanding, provided the total allocation to an individual issuer does not exceed 2%.
ICE BofAML 1-5 Y BB-B Cash Pay HY Index tracks the performance of BB rated U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market with maturities of 1 to 5 years.
The S&P 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The 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.
High yield corporate bonds are represented by the Bloomberg Barclays High Yield Corporate Index, which measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
Credit ratings agencies, such as Moody’s, Standard & Poor’s, and Fitch Ratings, have letter designations (such as AAA, B, CC) which represent the quality of a bond. Moody’s assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with WR and NR as withdrawn and not rated. Standard & Poor’s and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, and D.
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