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Market View

So far in 2018, high yield has outperformed investment grade, with lower-rated issues leading the way.

 

In Brief:

  • The lower end of high yield has continued to benefit from the benign environment for credit.
  • Nonetheless, the high-yield category has experienced more than $21 billion in outflows in the first six months of 2018.
  • Investors who are concerned about low spreads are trying to time the market and are missing out on the potential for strong returns.

 

We have published a series of articles regarding how various segments of the bond market historically have performed during periods of rising rates. Generally speaking, lower-duration and more credit-sensitive sectors of the market tend to outperform longer-duration, high-quality fixed-income securities. The first six months of 2018 have provided an example of such a period, as the yield on the 10-year U.S. Treasury bond has hovered near 3.0%, nearly 100 basis points (bps) higher than the levels of last fall. This week, we take a closer look at the high-yield bond market.

2018 Performance
As summarized in Chart 1, both U.S. and global high-yield bonds have generated positive returns, with the representative U.S. high-yield index (ICE BofAML U.S. High Yield Index) up 1.2% for the period ended July 31, 2018.  While that is hardly a stellar return for a seven-month period, it compares favorably to the 1.6% loss for the broad investment-grade market (as represented by the Bloomberg Barclays U.S. Aggregate Bond Index; “U.S. Aggregate”) and the 2.5% loss for investment-grade U.S. corporate bonds (as represented by the Bloomberg Barclays U.S. Corporate Bond Index).

 

Chart 1. So Far in 2018, High Yield Has Outperformed Investment Grade, with Lower-Rated Issues Leading the Way
Percent returns, as of July 31, 2018

Source: Bloomberg Barclays and ICE BofAML index data.  U.S. corporate investment grade represented by the Bloomberg Barclays U.S. Corporate Bond Index. U.S. aggregate represented by the Bloomberg Barclays U.S. Aggregate Bond Index. U.S. high yield-BB, U.S. high yield-B, and U.S. high yield-CCC are all subsets of U.S. high yield as represented by the ICE BofAML U.S. High Yield Index. Global high yield is represented by the ICE BofAML Global High Yield Index.
Past performance is not a reliable indicator or guarantee of future results. Performance during other periods may have been different. Other indexes may not have performed in the same manner under similar conditions. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

What has led to the outperformance of high yield? To start, the major driver of return for any fixed-income investment is yield, or carry. Coming into the year, the U.S high-yield index had an average yield of 5.84%, a significant advantage over the 2.71% yield of the U.S. Aggregate to start the year. The rise in U.S. Treasury yields, which has led to negative returns in many high-grade asset classes, has been partially offset by modest spread compression (unlike investment-grade corporate bonds, which have seen spreads widen this year). The combination of higher income and falling spreads helps offset the negative impact of higher Treasury yields.

This is not unusual, as higher Treasury yields often coincide with an improving economy, which should translate to an environment of improving corporate earnings, stronger credit fundamentals, and, therefore, lower credit spreads. As a result, while higher-quality bonds (such as the U.S. Aggregate) are more highly correlated with U.S. Treasuries, as one goes down the credit spectrum, bonds become more credit sensitive and less interest-rate sensitive. As a result, high-yield bonds historically have had negative correlation with U.S. Treasuries.        

A Closer Look Within High Yield
One finds further bifurcation within the high-yield market. While the broad high-yield market is positive, the highest-quality tier of the index, ‘BB’ rated bonds, are down for the year, while ‘CCC’ rated bonds are up 5.4%, a swing of more than 600 bps in year-to-date performance. Even within the high-yield index, the ‘BB’ rated component tends to have greater interest-rate sensitivity, owing not only to higher effective duration (as summarized in Table 1) but also to true rate sensitivity. Then if we go down in rating class, performance is driven more by credit, and is, in many cases, more idiosyncratic, reflecting the credit performance of the individual issues. So far in 2018, the environment of rising rates has provided a greater headwind to the ‘BB’ segment of the market. The lower end of high yield has continued to benefit from the benign environment for credit, with low default rates, a growing economy, and positive corporate credit fundamentals.

 

Table 1. To Date, Rising Rates Have Provided a Greater Headwind to the ‘BB’ Rated Segment of the Market
Index yield and duration, as of July 31, 2018

Source: Bloomberg Barclays and ICE BofAML index data. U.S. aggregate represented by the Bloomberg Barclays U.S. Aggregate Bond Index. U.S. high yield-BB, U.S. high yield-B, and U.S. high yield-CCC are all subsets of U.S. high yield as represented by the ICE BofAML U.S. High Yield Index.
Past performance is not a reliable indicator or guarantee of future results. Performance during other periods may have been different. Other indexes may not have performed in the same manner under similar conditions. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. 

 

A Longer-Term View
Extending to longer periods, high yield has delivered attractive returns relative to investment grade, more than doubling the return of the U.S. Aggregate over the trailing three-, five-, 10-, and 15-year periods.  True, those higher returns come with higher volatility than investment-grade bonds, but that needs some perspective: when compared to the equity market, high-yield bonds are much less volatile. Depending on the historical period (trailing three, five, 10, or 20 years), the high-yield index has exhibited 30–50% lower volatility than the S&P 500® Index. (A similar relationship holds when comparing the Global High Yield Index to the MSCI EAFE Index). In recent years, U.S. equities have had a very strong rally, and have delivered returns well ahead of the high-yield market. But going back over the trailing 20 years—a period that included the tech bubble burst of 2000–02, the credit crisis of 2008–09, and the energy collapse of 2015 (and subsequent recoveries)—high yield has delivered similar returns to the S&P 500, but with 40% lower volatility.

 

Chart 2. Historically, High-Yield Bonds Have Offered Equity-Like Returns with Lower Volatility, Long Term
Index returns and standard deviation, trailing 20 years, as of June 30, 2018

Source: Bloomberg Barclays and ICE BofAML index data. U.S. aggregate represented by the Bloomberg Barclays U.S. Aggregate Bond Index. U.S. high yield as represented by the ICE BofAML U.S. High Yield Index.  Global high yield is represented by the ICE BofAML Global High Yield Index. The S&P 500 represents the U.S. stock market.  EAFE (the MSCI EAFE Index) represents global developed-market equities. 
Past performance is not a reliable indicator or guarantee of future results. Performance during other periods may have been different. Other indexes may not have performed in the same manner under similar conditions. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Buyers Rush In?
Based on the return profile over the short and long term, one might expect huge inflows into high-yield mutual funds, as investors imprudently “chase returns.” But quite the opposite is true. Table 2 summarizes fund flows into the high-yield bond, intermediate-term bond, and the total across taxable fixed-income categories. The high-yield category has experienced more than $21 billion in outflows in the first six months of 2018, and there have been outflows in four of the past five calendar years. The $31 billion in outflows over the trailing three years is in stark contrast to the $343 billion added to the intermediate-term bond category, and the more than $730 billion that was invested across all fixed-income categories. In fact, of the 18 taxable fixed-income categories in Morningstar, high yield is one of only two categories in outflows over the past year.

 

Table 2. Year To Date, High-Yield Bonds Have Seen More Than $21 Billion in Outflows
Morningstar category fund flows, as of June 30, 2018

Source: Strategic Insights. Data represent Morningstar Category flows. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Why, then, are there outflows from high yield?  Some investors and analysts have voiced concern about the asset class, since the economy is in “the late innings” of the credit cycle, and credit spreads are below their long-term average. It certainly is true that spreads are below average.  As of the end of July 2018, spreads were near 350 bps over U.S. Treasuries, near the midpoint of the fairly tight range of 320–380 bps they have traded over the past year, and about 100 bps higher than their all-time lows reached in 2007.

But history has revealed that spreads can remain below average for extended periods of time, particularly during periods with positive economic growth and low default rates. If the economy were to stall, and head toward a recession, such events would lead to a negative environment for credit, and high yield likely would suffer losses. But given current economic readings, that does not seem likely to occur in the near term.

While spreads are low, it can still be a positive environment for high yield, given that:

  • Defaults remain low, and are currently running below 2%, according to JP Morgan data.
  • The U.S. economy appears sound. Unemployment is down to 4%, while second-quarter GDP (gross domestic product) growth of 4.1% was the highest reading in four years.
  • The quality of new issues has improved. Overall new-issue volume is down nearly 30% compared with last year. But in recent years, new issuance has been more weighted toward ‘BB’ rated bonds, with little in ‘CCC’ rated issuance; recent focus has been on refinancing rather than increasing leverage.
  • Credit fundamentals remain sound. Upgrades are outpacing downgrades at their fastest pace since 2011.

Given the overall interest-rate environment, one needs to temper return expectations. But with the overall move in rates, the average yield in the high-yield index has increased by about 100 bps off its lows last fall, to end July 2018 at 6.36%, putting high yield at a better starting point today than it was a year ago.

High Yield’s Role in a Portfolio
Many people would advise against trying to “time the market” for equities, but fund flows would suggest that is what investors have tried to do in high yield, missing out on strong returns. High yield historically has generated high returns relative to investment grade, has had negative correlation with U.S. Treasuries, generated positive returns in periods of rising rates, and over the long term delivered returns competitive with equities with much lower volatility. [High-yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them, may be subject to greater levels of credit and liquidity risk than portfolios that do not.]

Investors concerned about the duration risk in their high-quality intermediate-term portfolios may want to consider adding high yield as a complement in an effort to increase their yield and reduce their interest-rate sensitivity. Alternatively, for those who want to reduce their equity exposure following a strong rally in stocks, but still need growth, high yield may offer a lower-volatility alternative that over the long term has delivered attractive risk-adjusted returns relative to stocks.

 

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise. Lower-rated bonds may be subject to greater risk than higher-rated bonds. No investing strategy can overcome all market volatility or guarantee future results. Statements concerning financial market trends are based on current market conditions, which will fluctuate.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

basis point is one one-hundredth of a percentage point.

Duration is the change in the value of a fixed-income security that will result from a 1% change in market interest rates. Generally, the larger a portfolio’s duration, the greater the interest-rate risk or reward for underlying bond prices.

A bond yield is the amount of return an investor will realize on a bond.

Standard deviation is the measure of dispersion of a set of data from its mean. It measures the absolute variability of a distribution; the higher the dispersion or variability, the greater is the standard deviation and greater will be the magnitude of the deviation of the value from their mean.

The Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The Index covers the U.S. investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.

The Bloomberg Barclays U.S. Corporate Bond Index includes all publicly held issued, fixed-rate, nonconvertible investment-grade corporate debt.

The ICE BofAML Global High Yield Index tracks the performance of U.S. dollar-denominated, Canadian dollar-denominated, British pound-denominated, and euro-denominated below-investment-grade corporate debt publicly issued in the major domestic or eurobond markets.

The ICE BofAML U.S. High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.

The ICE BofAML CCC and Lower US High Yield Index,  The ICE BofAML BB High Yield Index, and  The ICE BofAML B US High Yield Index are all subsets of The ICE BofA ML US High Yield Index.

Source ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofAML INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofAML INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD ABBETT, OR ANY OF ITS PRODUCTS OR SERVICES.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

A Note about Indexes: Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Indexes depicted herein are for illustrative purposes only and do not represent any specific portfolios managed by Lord Abbett or any particular investments. Other indexes may not have performed in the same manner under similar conditions.

The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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