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Fixed-Income Insights

Investor jitters about price declines in oil and industrial commodities are creating attractive investment opportunities in the high-yield market relative to other fixed-income sectors.

 

In Brief

  • Plunging prices in the commodities markets are causing concerns among investors in the high-yield market.
  • As a result, U.S. high-yield securities are offering higher absolute yields and wider yield spreads than they were a year ago.
  • During past Fed tightening cycles, U.S. high yield generally has outperformed U.S. investment-grade debt.
  • A slower pace of Fed rate hikes in the upcoming cycle seems to favor the economic sensitivity of high-yield securities
  • The key takeaway—For investors able to tolerate some volatility and credit risk in exchange for what seems to be favorable performance characteristics as we approach, and even during,  a rate-normalization period, high-yield securities may be a worthy consideration.

 

High-yield securities are offering higher absolute yield and wider yield spreads today than they did a year ago, according to JP Morgan. And the chief reason behind that development is the recent decline in key commodity prices, notably oil and industrial metals.  Investors fear the plunge in oil prices will affect the profitability of energy companies, many of which are high-yield bond issuers, while reduced demand from China for copper, iron, ore, and other metals will hurt companies in the metals and mining sector, which also includes issuers of high-yield bonds.  Reflecting investor concerns, the energy sector and the metals and mining sector are the highest-yielding sectors currently of 21 sectors in the JP Morgan U.S. High Yield Index. While there are legitimate concerns in these sectors, there also are opportunities, particularly in oil pipelines and refiners. Moreover, investor concerns about commodity-related companies seem to have infected the high-yield asset class as a whole, including those issuers not even connected to oil and industrial commodities.  Jittery investors may have created opportunity.

In a global environment where yields of developed country debt frequently trade below historical levels of inflation and spreads of many corporate bonds are below historical averages, today’s pricing of U.S. high-yield debt may be appealing. Many companies have refinanced their debt, securing low interest expense for years to come. U.S. growth of about 2.5% creates a consistent and healthy environment for these companies. Moreover, at about 1.9% so far in 2015, defaults are about half their long-term average, according to JP Morgan. With such low levels of defaults, the yield spread offered by the high-yield asset class seems even more attractive. And with many high-yield companies focused in the United States and North America, adverse currency movements that affect exports and foreign earnings of larger global companies have less impact on overall high-yield earnings than in other asset classes. The combination of relatively strong balance sheets, attractive economic environment, reduced currency exposure, and low default risk may present U.S. high yield as an interesting investment to global investors seeking relatively attractive yield in a safe and persistently growing developed country, where potential currency appreciation could offer additional return benefits.

How Do Absolute Yields Compare Among Fixed-Income Alternatives?
Chart 1 illustrates that yields in the high-yield market compared favorably to many domestic fixed-income alternatives. The yield today is meaningfully higher than that available on traditional high-quality alternatives such as U.S. Treasuries or investment-grade corporate debt. (Also in the chart, the lower and more conservative “yield to worst” calculation was used for the high-yield asset class.)

 

Chart 1. Yields on U.S. High-Yield Bonds Compare Favorably to Other Fixed-Income Alternatives
(as of July 31, 2015)

Source: BofA Merrill Lynch, Barclays and Credit  Suisse.
1BofA Merrill Lynch U.S. 3-Month Treasury Bill Index. 2 Barclays U.S. Treasury Index. 3Barclays U.S. Baa Bond Index. 4 Credit Suisse High Yield Index.
Past performance is no guarantee of future results.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

What Happens to High Yield When the Federal Reserve Raises Rates?
While high yield seems attractively priced and holds interesting potential compared to other fixed-income alternatives, what can investors expect when the Fed raises rates? U.S. high yield in general is more economically sensitive and less interest-rate sensitive than many other U.S. fixed-income securities, particularly long-term high-quality debt. Accordingly, during past Fed tightening cycles, U.S. high yield generally has outperformed U.S. high-quality debt.

In the past 30 years, the Fed has needed to engage in rate-hiking cycles five times. As can be seen in Table 1, high yield outperformed two- and 10-year U.S. Treasuries and the representative benchmark Barclays U.S. Aggregate Index most of the time. The average performance of the high-yield index compares favorably to all the income alternatives shown.

 

Table 1. High-Yield Performance During Past Fed Tightening Cycles Also Offers Favorable Comparison to Alternatives

Source: New York Federal Reserve, Citigroup 2-Year U.S. Treasury Bond Index, Citigroup 10-Year Treasury Bond Index, Barclays U.S. Aggregate Bond Index, and BofA Merrill Lynch U.S. High Yield Master II Index.
Past performance is no guarantee of future results.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

While investors cannot rely on historical averages, they do provide a benchmark against which the current cycle can be judged and any differences can be evaluated. One factor differentiating this upcoming rate-hike cycle is the ultimate goal of the Fed. Past tightening cycles were designed to reduce high inflation by slowing the economy. Slower economic growth can contain investor interest in high yield, because lower-quality credits may not perform as well in a weaker economy. Despite the Fed’s intention to slow the economy in past cycles, high yield still outperformed its higher-quality fixed-income counterparts during most of these cycles. But the Fed’s intention during this cycle is different. In fact, it does not refer to it as “tightening” but rather as “rate normalization.” The Fed’s intent is not to slow the economy but to gently bring back rates without adversely affecting economic growth.

Some level of success in meeting this objective could allow even better high-yield performance than if the Fed were pursuing slower growth, while the interest-rate sensitivity of higher-quality securities could continue to hamper the returns of other fixed-income alternatives. In other words, the slower pace of Fed rate hikes in the upcoming cycle seems to favor the economic sensitivity of high-yield securities, potentially contributing to better relative performance than in past cycles when the Fed was intent on slowing the economy.

Instead of Rising Fed Funds, What Happens When Longer Rates Rise?
Over the past 25 years, there have been seven periods when the 10-year U.S. Treasury rose 100 basis points or more. High yield also performed relatively well in each of these periods, and consistently outperformed traditional high-quality fixed-income alternatives.

As Table 2 illustrates, the high-yield index outperformed short-, intermediate-, and longer-term high-quality debt, as measured by the two-year U.S. Treasury, the Barclays U.S. Aggregate, and the 10-year U.S. Treasury, in every period.

 

Table 2. During Periods of Sharply Rising Treasury Yields, Credit Sensitive Sectors of the Bond Market, Such as High-Yield Bonds, Historically Have Done Well
Index returns during the seven periods of greater than 100 basis-point rises in the 10-year Treasury yield (month-end returns)

Source: Federal Reserve Bank of New York, Barclays, BofA Merrill Lynch, and Citigroup.
1Citigroup 2-Year U.S. Treasury Benchmark Index. 2Barclays U.S. Aggregate Bond Index. 3 Citigroup 10-Year Treasury Bond Index. 4 BofA Merrill Lynch U.S. High Yield Master II Index.
Past performance is no guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

In terms of average performance of the seven rising-rate periods, the high-yield index, at 13.5%, has been far more attractive than the lower average returns of the other three alternatives listed. Even if we eliminate the extraordinary 2008–09 performance of high yield, the average return of the remaining six periods was 6.7%, which comfortably exceeds the average returns of the other options.

What about Volatility of Returns?
Chart 2 depicts the volatility of fixed-income returns since 1986, and compares that volatility to the return over the same period for each investment alternative.

 

Chart 2. U.S. Corporate Bonds Have Shown Attractive Risk/Reward

Source: Credit Suisse, Standard & Poor's, Barclays, FTSX, and Ibbotson.
Past performance is no guarantee of future results.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

The historical relationship between risk and reward statistically favors the two-year Treasury Index and the Barclays U.S. Aggregate Bond Index. Investors who are focused on low volatility may prefer these alternatives, especially if they have pursued risk elsewhere in their portfolio. However, investors seeking high yield may find the risk/reward characteristics of the high-yield index more consistent with their investment goals.

Conclusion
Concerns about the consequences of lower oil prices and lower commodity prices have been reflected among high-yield bonds, particularly the energy and the metals and mining sectors. As a result, the yield and yield spread of high-yield bonds are more attractive than they were 12 months ago, particularly in the context of slow but persistent U. S. growth and historically low default rates.

In anticipation of Fed rate normalization, it is interesting to note that the high-yield asset class has performed relatively well during past Fed rate-hiking cycles as well as during periods of generally rising rates. If the Fed delays its actions, high-yield securities could enjoy more time to compound relatively high interest income for a longer period, further distinguishing returns from those of lower-yielding, more interest-sensitive, higher-quality alternatives. For investors able to tolerate some volatility and credit risk in exchange for what seems to be favorable performance characteristics as we approach, then enter, a rate-normalization period, high-yield securities may be a worthy consideration. 

 

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