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Market View

Credit spreads on U.S. high-yield bonds reached all-time lows in June 2007—yet, high-yield bonds outperformed other major asset classes in the 10-year period that followed.

U.S. high-yield bonds have enjoyed strong returns thus far in 2017, with the representative BofA Merrill Lynch U.S. High Yield Constrained Index (High Yield Index) up more than 6% through the end of July.  Credit spreads have continued to compress amid a backdrop of strong credit fundamentals, low default rates, and steady, though modest, U.S. economic growth.  With this performance, the average spread on high-yield bonds versus U.S. Treasuries remains below the long-term average: as of June 30, 2017, the High Yield Index had an average spread of 390 basis points (bps) versus the long-term median of 513 bps (see Chart 1). (Other high-yield indexes have followed a similar trend, albeit with slightly different numbers.)

 

Chart 1. High-Yield Spreads Reached Historical Lows in June 2007
Spread to worst on the BofA Merrill Lynch U.S. High Yield Constrained Index, June 30, 1997–June 30, 2017

 

Source: BofA Merrill Lynch. Yield spreads represented by the BofA Merrill Lynch U.S. High Yield 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.

 

While spreads recently were below the long-term average, Lord Abbett remains constructive on the U.S. high-yield sector. With a base-case scenario of continued solid economic data in the United States and abroad, default rates on high-yield securities should continue to trend lower, leading to spreads remaining below their long-term average. 

It’s important to note that though spreads are below average, they have not reached all-time lows. That occurred a little over a decade ago, in early June 2007, when spreads reached 240 bps over Treasuries. We thought it would be instructive to look back at the trailing 10 years (ended May 31, 2017), assuming an investor had invested in high yield at the all-time low in spreads.  As illustrated in Chart 2, such an investor would have done quite well; high-yield bonds delivered an average annual return of 7.4%, higher than most major U.S. or global indexes in both the equity and fixed-income categories. [Of course, for the various historical performance attributes of the asset class mentioned in this article, there is no guarantee that U.S. high-yield bonds will perform in a similar manner in the future under similar circumstances.]

 

Chart 2. U.S. High Yield Has Outpaced Many Other Asset Classes Over the Past 10 Years
Historical total return on indicated asset classes, May 31, 2007–May 31, 2017

Source: Bloomberg, BoFA Merrill Lynch. High Yield=BofA Merrill Lynch U.S. High Yield Constrained Index. U.S. Large Cap Equities=S&P 500® Index. U.S. Small Cap Equities=Russell 2000® Index. IG (Investment-Grade) Corporates=Bloomberg Barclays U.S. Corporate Investment Grade Index. U.S. Aggregate Bond=Bloomberg Barclays U.S. Aggregate Bond Index. U.S. Treasuries=Bloomberg Barclays U.S. Treasury Index. Global Aggregate Bond= Bloomberg Barclays Global Aggregate Bond Index. International Equities=MSCI EAFE 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.

 

What happened in those 10 years? A look back over the past decade shows there have been some tumultuous periods. Shortly after spreads reached all-time lows, the collapse of two Bear Stearns hedge funds in June 2007 was an early signal of the financial crisis of 2008–09. High-yield bonds witnessed significant spread widening, ultimately peaking at 2,130 bps in December 2008.  This was double the level that had been experienced in previous difficult credit markets. Of course, this period of market distress was followed by a very strong recovery from these extreme spread levels in 2009. 

Still, it has not been smooth sailing in the post-crisis period, as evidenced by some anxiety-provoking events:

  • 2011 – As the Greek debt crisis unfolded in Europe, S&P Global took an historical step by downgrading the credit rating of U.S. government debt in August.  During this risk-off environment, high-yield spreads widened by 450 bps between February and October.
  • 2013 – The market’s “taper tantrum” spurred by indications from the U.S. Federal Reserve that it would begin to unwind its stimulative bond-purchase program led to a significant rise in U.S. Treasury yields, and fostered volatility in the credit markets. High-yield spreads widened by more than 100 bps during the May-June period.
  • 2014–15 – A collapse in the price of oil and other commodities put significant pressure on the high-yield market, with spreads rising by 550 bps between June 2014 and February 2016.

But these events did not seriously compromise the market’s longer-term performance. If an investor had invested in high yield in June 2007—arguably the worst possible time to invest—things still would have worked out quite well over the following 10 years.  (Obviously, there is no guarantee that things would play out the same way under a similar scenario in the future.)  

Of course, spreads only tell part of the story; one also must consider the overall level of interest rates.  Over the past decade, U.S. Treasury yields generally have been declining, supporting all bond prices.  That downtrend in rates would have been supportive of Treasuries and other investment-grade bonds as well—in fact, duration would have been more of a tailwind for the investment-grade indexes referenced in Chart 2, since high yield has a lower effective duration (for example, as of June 30, 2017, the High Yield Index had an effective duration of 4.0, versus 6.0, 6.1, and 7.5, respectively, for the Bloomberg Barclays U.S. Aggregate Bond Index, the Bloomberg Barclays U.S. Treasury Index, and the Bloomberg Barclays U.S. Corporate Investment Grade Index).  But despite the duration advantage of investment grade, high-yield bonds have outperformed the U.S. Aggregate and U.S. Treasury indexes by 3%, per year, over the past decade.

When compared to the broad equity indexes, the return advantage of high yield becomes more impressive when volatility is taken into account.  Since high yield has had 30% lower volatility (as measured by standard deviation) than large-cap equities, and roughly half the volatility of small-cap equities, the result has been much higher risk-adjusted returns. (See Table 1.)

 

Table 1. Over the Past 10 Years, High Yield Offered Higher Returns with Lower Risk Than Equities

Source: Morningstar. High Yield Bonds=BofA Merrill Lynch U.S. High Yield Constrained Index. U.S. Large Cap Equities=S&P 500 Index. U.S. Small Cap Equities=Russell 2000 Index. International Equities=MSCI EAFE 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 table 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.

 

But that is not unusual. Over longer holding periods, high yield historically has provided similar returns to the S&P 500® Index, but with much lower volatility. As a result, based on any rolling 10-year period since its inception, the High Yield Index has consistently generated higher risk-adjusted returns than equities (as measured by Sharpe ratio), as illustrated in Chart 3.

 

Chart 3. Historically, High Yield Has Posted Higher Risk-Adjusted Returns Than Equities
Sharpe ratio of indicated asset classes, January 1, 2007–December 31, 2016

Source: Zephyr. High yield represented by the BofA Merrill Lynch U.S. High Yield Constrained Index; U.S. equities represented by the S&P 500 Index.
Past performance is not a reliable indicator or guarantee of future results. 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.

 

Summary
To be clear, we are not suggesting that the next 10 years will play out exactly as the previous 10 years have.  But the performance numbers from this past decade help illustrate the attractive risk-reward profile of high-yield bonds, even when investing at what seems like the worst possible time.  Would returns have been higher if you waited until 2009 to invest in high yield?  Of course—but most people were too afraid to buy anything other than ultra-safe, low-yielding investments in 2009. 

Investors often are cautioned to not try to “time the market” when it comes to equity investing. (We have touched on the pitfalls of market timing in previous Market Views.) Based on the long-term risk/reward profile of the high-yield market, perhaps one should apply a similar philosophy to high yield.  Given the high current income, attractive risk-adjusted returns, and strong performance during past periods of rising U.S. Treasury yields, investors may want to maintain an allocation to high-yield bonds—even at a time when spreads are below average. 

 

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