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Market View

High-yield corporate bonds still present a compelling opportunity, despite tighter credit spreads.

High-yield bonds have performed very well over the past year, with the Bank of America Merrill Lynch High Yield Master II Constrained Index returning 12.65% for the 12-month period ended June 9, 2017. Although positive performance has come with tighter credit spreads, here are five reasons why we believe investors should continue to consider an allocation to below investment-grade U.S. corporate bonds.     

1. Default Rates Are Low
Corporate credit spreads reflect the market’s perception of and appetite for risk. From a macro perspective, widening credit spreads may be a sign of challenges for the general economy, accompanied by a “risk-off” temperament in the market. On a more micro level, a widening spread could indicate a growing concern regarding the ability of a borrower to service its debt and the possibility of default. Inversely, narrowing credit spreads may indicate a greater confidence in the ability of an issuer, or issuers in general, to make scheduled interest and principal payments.

Comparing default data to credit spreads supports this claim. High-yield spreads have narrowed considerably from their three-year month-end high, from 833 basis points (bps), on January 31, 2016, to 440 bps, on May 31, 2017.1 Meanwhile, as of May 31, 2017, the trailing 12-month default rate on the J.P. Morgan High Yield Bond Index was 1.31%. This compares with the 3.75% long-term average. Not only are default rates low today, but also Credit Suisse expects them to decline over the next 12 months. 

 

Chart 1. Default Rates Have Trended Lower
As of May 31, 2017

Source: J.P. Morgan. The historical data shown are for illustrative purposes only and do not represent any specific portfolio by Lord Abbett or any particular investment. Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results.

 

The point is, with trailing default rates well below their long-term averages and expectations that defaults will remain relatively low, it makes sense that credit spreads are lower as well.

2. Credit Quality Has Improved
Consistent with low default rates is evidence of rising overall credit quality. Nearly 50% of the Bank of America Merrill Lynch High Yield Bond Index was rated 'BB' as of December 31, 2016, up from 38% 10 years ago. Naturally, as credit quality has increased, credit spreads—the compensation for credit risk—have decreased.

 

Chart 2. High-Yield Credit Quality Has Improved Over the Past Decade
Credit quality breakdown of the high-yield market, 2006–16

Source: BofA Merrill Lynch High Yield Index. The historical data shown are for illustrative purposes only and do not represent any specific portfolio by Lord Abbett or any particular investment. Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results. Indexes are unmanaged and are not available for direct investment.

 

What is more, the use of issuance proceeds has shifted predominantly to refinancing activity. Since 2011, on average nearly 60% of proceeds have been used to pay down existing, more costly debt—typically viewed a “credit positive” trend—compared to engaging in more speculative borrowing, such as issuing debt to finance an acquisition.

 

Chart 3. Companies Are Paying Down Existing Debt
High-yield issuance, by use of proceeds, as of June 1, 2017

Source: J.P. Morgan. The historical data shown are for illustrative purposes only and do not represent any specific portfolio by Lord Abbett or any particular investment. Data updated quarterly.

 

3. High Relative Income
As shown in Chart 1, not only have spreads narrowed as default rates have fallen but also spreads can remain low for extended periods of time. In fact, over the five-plus years from April 1993 through July 1998 and the three-plus years from April 2004 through October 2007, spreads remained range-bound at levels near or, in many cases, lower than those of today, according to J.P. Morgan. As illustrated in Chart 4, in this kind of environment, when yields have fallen on an absolute level, we believe that below investment-grade corporate bonds still offer attractive income relative to other fixed-income sectors.

 

Chart 4. Currently, High-Yield Bonds Offer Attractive Relative Yield
Yields on fixed-income indexes, as of May 31, 2017

Source: Bloomberg Barclays, BofA Merrill Lynch, and Credit Suisse. The historical data shown are for illustrative purposes only and do not represent any specific portfolio by Lord Abbett or any particular investment.
BofA Merrill Lynch U.S. Treasury Bill 3-Month Index. Bloomberg Barclays U.S. Treasury Yield Index. 3 Bloomberg Barclays ABS Index. Bloomberg Barclays U.S. Mortgage Backed Securities Index. 5 Bloomberg Barclays CMBS Aaa-Rated 7+Year Index.  Bloomberg Barclays U.S. Corporate A-Rated Index. Bloomberg Barclays U.S. Corporate Baa-Rated Index. 8 Credit Suisse Leveraged Loan Index (Discount Margin 3-Year Life). 9 J.P. Morgan CEMBI Broad Diversified Index. 10 Credit Suisse High Yield Index (Yield to Worst).
Source: Bloomberg Barclays, BofA Merrill Lynch, and Credit Suisse. The historical data shown are for illustrative purposes only and do not represent any specific portfolio by Lord Abbett or any particular investment.
Due to market volatility, the market may not perform in a similar manner in the future. Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results. Indexes are unmanaged and are not available for direct investment.

 

4. Attractive, Long-Term Risk-Reward Profile
In our view, investors trying to time the high-yield market are typically asking the wrong question. Instead of “Should I own high-yield bonds today or not?” data suggest that investors may be better served by asking, “How much of my portfolio should be allocated strategically to high-yield bonds?” Although tactically increasing or decreasing allocations to high-yield bonds may be prudent based on relative value, economic developments, and/or fluctuating market conditions, we believe that a strategic allocation to this asset class may represent a sound approach for those investors with long-term horizons and a tolerance for risk.

While past performance is not a guarantee of future results, over the past 25 years, high-yield bonds have delivered nearly 90% of the return of equities, with roughly half the volatility. This has led to attractive risk-adjusted returns, as measured by the Sharpe ratio.

 

Chart 5. High-Yield Bonds Have Offered Strong Higher Risk-Adjusted Returns
U.S. high yield versus U.S. equities, January 1, 1992–May 31, 2017

Source: Credit Suisse. *High-yield bonds are represented by the Credit Suisse High Yield Index. **Stocks are represented by the S&P 500® Index. The historical data shown are for illustrative purposes only and do not represent any specific portfolio by Lord Abbett or any particular investment. Stocks are subject to greater risk and market volatility, while bonds are subject to greater risk of default and interest rate volatility. Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results. Indexes are unmanaged and are not available for direct investment.

 

5. Performance in Rising-Rate Environments
By definition, the performance of credit-sensitive bonds, like high yield, tends to be more influenced by the trajectory of the economy as compared to interest rate-sensitive bonds. Historically, as the economic backdrop improves, credit fundamentals strengthen and investor demand for riskier assets typically increases, leading to strong relative performance.

 

Table 1. Historically, in Periods of Rising Rates, High-Yield Bonds Have Performed Well
Index returns during the eight periods of greater than 100 basis-point rise in the 10-year U.S. Treasury yield; month-end, annualized returns

Source: Citigroup, Bloomberg Barclays, BofA Merrill Lynch. The historical data shown are for illustrative purposes only and do not represent any specific portfolio by Lord Abbett or any particular investment. Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
1 Citigroup 10-Year Treasury Bond Index.
2 Bloomberg Barclays U.S. Aggregate Bond Index.
3 BofA Merrill High Yield Master II Index.

 

Summary
While there are always risks, including the possibility of price volatility, illiquidity, and defaults, we believe a strong case can be made for allocating to high-yield bonds today. Credit spreads have narrowed as the U.S. economy and corporate creditworthiness have strengthened, default rates have declined, and credit quality has improved. In addition, high-yield issuers have reduced their debt burdens by using the proceeds of debt issuance to refinance older, more costly debt. Although absolute yields may be low by historical standards, we believe high-yield bonds still offer attractive income relative to other asset classes. From a performance perspective, high-yield bonds historically have delivered nearly 90% of the return of equities, with roughly half the volatility. Finally, the performance of high yield during periods of rising interest rates—typically occurring when the economy is improving—historically has been strong.

 

1 Using data from the J.P. Morgan High Yield Bond Index.

 

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