Don’t let record low rates sway you. High yield still has the potential to enhance income and total return, lower interest rate volatility, and diversify risk in fixed income portfolios.
With rates anchored lower for the foreseeable future, fixed income investors seeking more yield only have a few levers to pull—extend duration, take more credit risk, or venture into currency/country risk (via emerging markets) as the volume of negative yielding debt around the world has hit a record $18 trillion.
Enter high yield, a category that has demonstrated compelling risk-adjusted returns over multiple market cycles with significantly lower duration (3.56 years) than investment grade bonds (8.83 years), according to Bloomberg.
High Yield Bonds Deliver Competitive Returns Per Unit of Risk
Source: Standard & Poor’s, FTSE Russell, Bloomberg Barclays
The High Yield, Leveraged Loan, Large Cap Equity & Small Cap Equity Markets are represented by the Bloomberg Barclays U.S. Corporate High Yield Index, S&P 500® Index & the Russell 2000® Index, respectively. Returns were calculated using monthly and begin with the inception of the Credit Suisse Leveraged Loan Index on 1/1/92
Past performance is not indicative of future results.
Granted, massive inflows into high yield have driven yields down lately, but the asset class remains durable. As the chart below shows, the yield to worst from U.S. high yield corporate bonds (as represented by the Bloomberg Barclays U.S. Corporate High Yield Total Return Index) was 4.72% as of 11/30/20—more than double that of investment grade corporates’ YTW of 1.8% (as represented by the Bloomberg Barclays U.S. Corporate Investment Grade Bond Index), to cite just one example. (See chart below.)
U.S. Corporate High Yield Still Exhibits Favorable Yield and Duration Characteristics Yield to worst (YTW), duration in years, YTW per unit of duration
Source: Bloomberg and JPMorgan. Data as of 11/30/20. Underlying Indexes represented in chart are defined below.
Our recent focus has been identifying the hardest hit sectors due to the shutdown of the economy to identify good businesses with ample liquidity to make it through the economic slowdown. Our expectation is that many of these credits will bounce back strongly once we get to the “new normal”. Since November 9 (when Pfizer announced significant progress with its COVID vaccine candidate), we have been reducing our exposure to these resilient sectors/credits and are now about 1.5x the benchmark weight. We have also been buying more defensive names as we sell our COVID credits. From the perspective of 12 to 18 months, the COVID bucket remains the area that we believe offers the best potential value, but we will likely continue to reduce into strength so we have room to add if we experience some market volatility.
From a valuation perspective, we are still about 75 bps wide on an option adjusted spread basis relative to where we began the year (we were tighter than that in 1Q). This is despite the high overall default rate cleansing the weakest credits from the asset class in addition to the significant fallen angels that brought former investment grade credits into high yield. On an apples-to-apples basis, we have some room to run to get back to where we were in January.
Defaults Appear to be Heading Lower
Includes distressed exchanges. Source: JPMorgan. Data as of 11-30-20.
We believe the economic growth through 2021 and into 2022 should be solid and defaults should peak soon if they have not already. (Note: November was the first month without any default activity since August 2018.) This should provide a decent backdrop for some continued spread tightening. Further, increased profitability/productivity could be a positive surprise as we get to the “new normal”. As an example, regional gaming companies are suggesting they can operate profitably at 50% of historical revenue, and we are hearing similar assertions from other companies.
Having said that, we could see some volatility due to: rising COVID cases and deaths resulting in regional shutdowns and/or increases in restrictions; Georgia elections; potentially disappointing vaccine news in terms of rollout, and/or efficacy; or disappointments with additional stimulus. However, we would generally consider market volatility as an opportunity to add some yield.
High Yield Spreads Offer an Attractive Entry Point
Past performance is not indicative of future results.
Source: ICE BofA Indices as of 11/30/20
Current High Yield Spreads Still Offer the Potential for Robust Long-Term Total Returns U.S. High Yield Spread to Worst Vs. 12-Month Forward Return
Past performance is not indicative of future results.
The J.P. Morgan U.S. High Yield Index is designed to mirror the investable universe of the U.S. dollar domestic high yield corporate debt market. The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and it is not available for direct investment.
Source: JPMorgan analysis as of 8/31/20
High yield can still offer a compelling way for fixed income investors to pursue higher long-term returns than is available in most other fixed income sectors (for those willing to accept higher volatility) AND a way for equity investors to trim their allocations and pursue decent longer term returns with an expectation of lower volatility.
Of course, the risk/reward relationship and the prospect for elevated volatility in high yield can’t be ignored. This environment demands differentiated active management, meticulous bond-by-bond research, and a selective approach focused on quality.
The commentary is the opinion of the subadviser. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities. Forward-looking statements are necessarily speculative in nature. It can be expected that some or all of the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes.
A fallen angel is a bond that was previously investment grade (> BBB- / Baa3) but has since been reduced to speculative grade (< BB+ / Ba1).
The Bloomberg Barclays U.S. Corporate High Yield Bond Index measures fixed rate non-investment grade debt securities of U.S. corporations, calculated on a total return basis.
The Bloomberg Barclays U.S. Corporate Investment Grade Bond Index measures performance of investment grade corporate bond funds. The index is calculated on a total return basis.
The Bloomberg Barclays Pan-European High Yield Index covers the universe of fixed-rate, sub-investment-grade debt denominated in euros or other European currencies (except Swiss francs). This index includes only euro and sterling-denominated bonds, because no issues in the other European currencies now meet all the index requirements.
The JP Morgan Emerging Markets Bond Index Global (EMBI Global) tracks total returns for traded external debt instruments in the emerging markets, and is an expanded version of the EMBI+. As with the EMBI+, the EMBI Global includes U.S. dollar-denominated Brady bonds, loans and eurobonds with an outstanding face value of at least $500 million.
The Bloomberg Barclays Mortgage Index covers the mortgage-backed, pass-through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC). This index is the mortgage-backed securities, fixed rate component of the Barclays U.S. Aggregate Index.
The Bloomberg Barclays U.S. Corporate Index is a broad-based benchmark that measures the investment-grade, fixed-rate, taxable, corporate bond market.
The Bloomberg Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury.
The Bloomberg Barclays Euro Aggregate Corporate Bond Index measures the investment-grade, euro-denominated, fixed-rate bond market of corporate issues. This index is the corporate bond component of the Bloomberg Barclays Euro Aggregate Bond Index. The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index.
A Basis Point (bp) is equal to 0.01%. Credit Ratings noted herein are calculated based on S&P, Moody’s and Fitch ratings. Generally, ratings range from AAA, the highest quality rating, to D, the lowest, with BBB and above being called investment grade securities. BB and below are considered below investment grade securities. If the ratings from all three agencies are available, securities will be assigned the median rating based on the numerical equivalents. If the ratings are available from only two of the agencies, the more conservative of the ratings will be assigned to the security. If the rating is available from only one agency, then that rating will be used. Ratings do not apply to a fund or to a fund’s shares. Ratings are subject to change. Default Rate is most commonly referred to as the percentage of loans that have been charged off after a prolonged period of missed payments. Defaulted loans are typically written off from an issuer’s financial statements and transferred to a collection agency. In some cases, a default rate may also be a higher interest rate charged to a borrower after a specified number of missed payments occur. Effective Duration The change in the value of a fixed income security that will result from a 1% change in interest rates while taking into account the way changes in rates will affect the expected cash flows of any bond with an embedded option such as call or prepayment option. This measure assigns a probability to the exercise of a call option, where applicable, based on specified shifts in the yield curve. Duration is expressed as a number of years, and generally, the larger the duration, the greater the interest rate risk or reward for a portfolio’s underlying bond prices. Standard Deviation measures variability of returns around the average return for an investment portfolio. Higher standard deviation suggests greater risk. Spread to worst in bond markets is the difference between the yield-to-worst (YTW) of a bond and yield-to-worst of a U.S. Treasury security with similar duration. Yield to worst (YTW) is the lowest yield an investor can expect when investing in a callable bond.
IMPORTANT RISK CONSIDERATIONS
Fundamental Risk of Investing: There can be no assurance that the fund will achieve its investment objectives. An investment in the shares of the fund is subject to the risk of loss of principal; shares may decrease in value. Credit & Interest: Debt securities are subject to various risks, the most prominent of which are credit and interest rate risk. The issuer of a debt security may fail to make interest and/or principal payments. Values of debt securities may rise or fall in response to changes in interest rates, and this risk may be enhanced with longer-term maturities. Foreign & Emerging Markets: Investing internationally, especially in emerging markets, involves additional risks such as currency, political, accounting, economic, and market risk. High Yield-High Risk Fixed Income Securities: There is a greater level of credit risk and price volatility involved with high yield securities than investment grade securities. Industry/Sector Concentration: A fund that focuses its investments in a particular industry or sector will be more sensitive to conditions that affect that industry or sector than a non-concentrated fund. Market Volatility: Local, regional, or global events such as war, acts of terrorism, the spread of infectious illness or other public health issues, recessions, or other events could have a significant impact on the portfolio and its investments, including hampering the ability of the portfolio manager(s) to invest the portfolio’s assets as intended. Prospectus: For additional information on risks, please see the fund’s prospectus.
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