Multi-Sector Bonds: Four Key Themes for Today’s Market | Lord Abbett
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Market View

What are the key considerations for investors in multi-sector bond strategies in the current environment? Our experts offer their views.

Read time: 5 minutes

With yields low and uncertainty high, this may be an opportune time for investors to consider multi-sector bond strategies. These strategies, which offer portfolio managers the flexibility to invest across multiple sectors of the market—for example, high yield, investment grade, and structured products such as commercial mortgage-backed securities—may prove appealing to those who are looking for higher yield and return potential versus core bonds, but with less credit risk than a pure allocation to high yield.

A recent presentation for professional investors featuring Lord Abbett Partner and Co-Head of Taxable Fixed Income Steven Rocco and Director of Product Strategy Stephen Hillebrecht focused on multi-sector fixed income strategies. Here, we summarize selected observations on the asset class from our experts.

  1. High yield spreads

As we entered 2020, spreads on the benchmark ICE BofA U.S. High Yield Constrained Index were just below 375 basis points (bps). During the COVID-fueled market volatility, spreads shot up to nearly 1100 bps in March before the market started to recover. However, they remain above levels seen prior to the emergence of the virus (See Figure 1)

 

Figure 1. U.S. High Yield Spreads Have Narrowed Considerably, But Are Still Above Early 2020 Levels

Spread on the ICE BofA U.S. High Yield Constrained Index, September 30, 1998–October 30, 2020

Source: ICE Data Indices, LLC. Yield spreads represented by the ICE BofA U.S. High Yield Constrained Index.

Past performance is not a reliable indicator or guarantee of future results. It is important to note that the high-yield market may not perform in a similar manner under similar conditions in the future. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Bps represents a basis point. One basis point equals 0.01%.

 

Obviously, the strength of the move we’ve already had is something to consider. But we believe U.S. high yield market conditions remain favorable. For one thing, the credit markets have been open—witness the record issuance of high yield bonds used to refinance existing debt, pushing out maturities and shoring up balance sheets. Since companies have extended their debt maturities, only around 4% of high yield bonds currently issued will mature by the end of 2021, according to data from J.P. Morgan.

With a stronger-than-anticipated U.S. economic recovery providing another tailwind, many analysts have reduced their default expectations from what was forecast just a few months ago. Even so, investors have been defensively positioned, so with a lot of cash on the sidelines and a shortage of yield in the market, we could potentially see stronger demand for high yield bonds.

Could spreads get back to February’s levels? We think that’s possible, maybe not by the end of this year, but certainly at some point in the New Year. That would represent an opportunity for additional return down the road. Expectations of potential returns should be kept in context, as starting spreads are at a much narrower point than earlier in the year.

  1. Credit quality trends

Any examination of current spreads needs to be put in context of a changing high yield landscape.  Given that the spate of high yield issuance has been geared towards the ‘BB’ rating category, the overall quality of the benchmark high yield index has improved to the highest point in its history. Figure 2 shows that over the past decade or so, the credit profile of the benchmark index has basically flipped in terms of the ‘BB’ and ‘B’ exposure.

 

Figure 2. The Credit Quality of the High Yield Market Has Improved Markedly

Credit-rating composition of the ICE BofA U.S. High Yield Constrained Index as of the indicated dates

Source: ICE BofA U.S. High Yield Constrained Index as of 09/30/2020. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or guarantee of future results.

 

We think this credit quality breakdown argues for a re-examination of high yield valuations. When you're looking at spreads versus history, remember that the index is of a far higher credit quality at this point. So, all else being equal, one would expect spreads to be below the long-term average.

What about the investment grade side? We’ve written about the large contingent of so-called “fallen angel” bonds (i.e., those whose ratings have been reduced to below investment grade) that entered the high-yield index, especially in March and April. after a wave of downgrades from the major rating agencies. But the pace of downgrades has slowed markedly since then (see Figure 3), which has helped to ease credit concerns in the market.

 

Figure 3. The Pace of Investment Grade Credit Downgrades Has Slowed Greatly in Recent Months

Source: JPMorgan. Data as of 09/30/2020 (latest quarterly data). Chart depicts rating actions on non-financial investment grade corporates, excluding emerging markets. 

For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. 

 

  1. Current characteristics of core bonds

Why would investors want to consider credit-focused strategies in today’s market?  Investors in traditional core bond strategies may find themselves in a difficult situation: Low rates and rising interest-rate risk. Look at Figure 4, which shows the yield and the duration of the Bloomberg Barclays U.S. Aggregate Bond Index (the “Agg”), which we consider a good proxy for the typical intermediate core bond strategy. Over the past decade, the duration of the “Agg” has extended by about 50%, while its yield has declined by about 75%.

 

Figure 4. Core Bond Yields Have Declined as Duration Has Extended

Duration and yield of the Bloomberg Barclays U.S. Aggregate Bond Index, January 31, 2001–October 31, 2020

Source: Bloomberg Index Services Limited. Data as of October 31, 2020 (latest month-end).

Past performance is not a reliable indicator or guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

That’s not an appealing state of affairs. While interest rates don’t seem likely to spike higher in coming months, in our view, it would only take a small move higher in rates to wipe out much of the return that core bond investors are realizing at current levels.

  1. The continuing appeal of a multi-sector approach

What might core-bond investors do to mitigate that situation? One approach might be an allocation to multi-sector, as a complement to a core bond holding. We believe such strategies can take advantage of higher yields available in segments of the market such as high yield corporates, investment grade corporates, bank loans, and emerging market debt.  A multi-sector approach can provide broad diversification across sectors, with the flexibility to adjust allocations to adapt to the market environment as conditions change. This creates a greater opportunity for enhanced total return, in our view.

Another important attribute is effective historical diversification across many sectors (see Figure 5), especially given the negative correlation of credit-sensitive areas of the market versus core bonds. This diversification profile also means that multi-sector has offered historically lower volatility than a pure high yield allocation.

 

Figure 5. Historically, a Multi-Sector Approach Has Offered Enhanced Diversification

Correlation with Bloomberg Barclays U.S. Government Index, January 1, 2010–September 30, 2020

1Bloomberg Barclays U.S. Aggregate Bond Index. 2Bloomberg Barclays U.S. Treasury U.S. TIPS Index. 3Bloomberg Barclays U.S. Corporate Baa-Rated Index.  4Bloomberg Barclays U.S. Corporate High Yield Index.  5S&P 500 Index. 6ICE BofA All Convertibles All Qualities Index.  7Credit Suisse Leveraged Loan Index.
Source: Morningstar. Data as of September 30, 2020 (latest available quarterly data). Correlation is a statistic that measures the degree of association between two variables.

Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

A Final Word

The current state of the bond market—historically low interest rates with historically high duration—continues to pose challenges for core bond investors. For those who are seeking enhanced yield and total return potential but not willing to take the risk of pure high yield, a diversified multi-sector bond strategy may make sense as part of a thoughtfully constructed investment portfolio.

 

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 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. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. 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. 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. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This commentary 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.

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.

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

Correlation is a statistic that measures the degree of association between two variables.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.

Fallen angels refers to bonds that have been downgraded from investment grade to speculative grade status.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point).

Spread-to-worst measures the dispersion of returns between the best and worst performing security in a given market, usually bond markets, or between returns from different markets.

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 High Yield Bond Index is a market value-weighted index which covers the U.S. non-investment grade fixed-rate debt market. The index is composed of U.S. dollar-denominated corporate debt in Industrial, Utility, and Finance sectors with a minimum $150 million par amount outstanding and a maturity greater than 1 year. The index includes reinvestment of income.

The Bloomberg Barclays U.S. TIPS Index is an unmanaged index comprised of U.S. Treasury Inflation Protected Securities with at least $1 billion in outstanding face value.

The Bloomberg Barclays U.S. Corporate Baa-Rated Bond Index is a rating-specific subset of the Bloomberg Barclays U.S. Corporate Bond Index, which includes all publicly held issued, fixed-rate, nonconvertible investment-grade corporate debt.  The index is composed of both U.S. and Brady bonds.

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market.

The ICE BofA All Convertibles, All Qualities Index contains issues that have a greater than $50 million aggregate market value. The issues are U.S. dollar-denominated, sold into the U.S. market and publicly traded in the United States.

The ICE BofA U.S. High Yield Constrained Index is a rules-based index consisting of U.S. dollar-denominated, high yield corporate bonds for sale in the U.S. The index is designed to provide a broad representation of the U.S. dollar-denominated high yield corporate bond market. The index is a modified market value-weighted index with a cap on each issuer of 2%.

ICE BofA Index Information:

Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofA 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 BofA 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 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. 

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The credit quality of the securities are 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 principle on these securities.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.  If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in this commentary 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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