The Fed jumps into the high yield bond market

by: , Chief Investment Officer and Managing Director | IndexIQ; IndexIQ,

On April 9th, the U.S. Federal Reserve announced a dramatic expansion of its lending program with plans to inject as much as $2.3 trillion into the economy. Included in the mix were selected high yield bonds. Some of this was a reaction to the fundamentals – the economy has slowed dramatically and corporate bonds have sold off on concerns about credit quality – but it also reflects worries over the impact that a sudden loss of liquidity has had on the market.

Markets need liquidity – a more or less equal match in interest between buyers and sellers – to function smoothly. But in a crisis, liquidity often evaporates as fundamental values are pushed aside in the rush for the exits. As buyers disappear, efficient price discovery vanishes. Experience has shown that with time, liquidity, returns and prices generally recover to better reflect the fundamental value of the underlying assets, but we are obviously in uncharted waters right now and it’s effectively anyone’s guess as to when things might return to anything like normal. So the Fed’s decision to buy bonds, and to extend its program to segments of the high yield end of the market, is designed to address those liquidity issues, providing a bridge to the point when markets can function normally on their own.

The unprecedented move clearly had an impact. Following the Fed action, high yield spreads relative to treasuries tightened dramatically and high yield bond prices jumped. This seemed to confirm that at least part of the market decline was liquidity driven. In the final analysis, the market will have its say and lower rated credits are likely to struggle as the economy stays on its coronavirus-driven lockdown. But, again, a lesson from past crises is that asset prices have tended to recover over time, rewarding patience on the part of investors.

Elevated levels of volatility can make it hard to be patient, however. In high yield as elsewhere, diversification can help investors weather this period of uncertainty. An ETF built on an underlying methodology that includes a broad portfolio of lower volatility, high yield bonds diversified by sector is one approach. IQ S&P High Yield Low Volatility Bond ETF (HYLV) Besides the potential for a recovery in asset prices, there are other benefits to staying the course.  A non-intuitive one is the impact on dividend reinvestment.

As prices decline, reinvested dividends allow an investor to expand a position at lower cost, a kind of automated dollar cost averaging. At the same time, the decline in asset prices often means that the effective yield of a fund goes up, so that new money generates a higher level of income (which can itself be reinvested). Because bond funds and ETFs pay dividends on a monthly basis, the impact of this reinvestment strategy can be seen quickly.

In times of crisis, money tends to gravitate towards U.S. Treasuries and other safe havens, and away from credit assets like high yield bonds. Some of this is rational; some driven by fear. Even the most committed efficient market theorist would have to admit that there are times when markets behave in inefficient ways. It seems to us that we are in the midst of one of those periods. By its actions, the Fed seems to think so, too. While its decision to step into the high yield market for the first time ever is an important one, we are not out of the woods yet.  Investors should take notice of the Fed’s action and give thought to the various ways high yield exposure has been and can continue to be included in an overall fixed income portfolio. One of those ways may be to consider investing in lower volatility high yield bonds.

Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value. Diversification cannot assure a profit or protect against loss in a declining market.

Click on the fund name for the most current fund page, which includes, the prospectus, investment objectives, performance, risk, and other important information. Returns represent past performance which is no guarantee of future results. Current performance may be lower or higher. Investment return and principal value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. Visit nylinvestments.com/etfs and nylinvestments.com/funds and for the most recent month-end performance.

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.

Dollar cost averaging is a strategy in which an investor places a fixed dollar amount into a given investment on a regular basis. The investment generally takes place each and every month regardless of what is occurring in the financial markets.

“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs. 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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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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