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(First of two parts. Read Part II here.)
Most investors that have been drawn to the high-yield bond market's potential for total returns and lower historical volatility, compared to equities, have not been disappointed in recent years. While there is no guarantee that the asset class will perform in a similar manner in the future, these attributes may continue to validate the asset class as a long-term holding in many portfolios. Yet, headlines about easing credit quality and equities' record-setting gains may have some investors considering a shorter time horizon for the securities.
In this environment, some perspective on the questions that may be confronting investors could help determine the role that high yield might play in their portfolios going forward.
Q. What is the likely impact on the U.S. high-yield bond market if a "great rotation" from fixed income into equities unfolds?
There are multiple considerations regarding the effect that a potential rotation into equities might have on fixed-income assets. The first is whether such a rotation is even underway. It would be difficult to make that case, considering that flows into fixed-income strategies continued to outpace those going into equity strategies in the first quarter of 2013.1
Meanwhile, the assets in money market funds contracted by about 4% during the first quarter, according to the Investment Company Institute. This suggests that a significant amount of the recent equity flows may have come from money market funds rather than the bond market. While this movement might reflect some of the success that the Federal Reserve has had in persuading investors to move out of the most conservative assets, it may be surprising to many if investors have indeed shifted from one of the most conservative assets directly into one at the other end of the risk spectrum.
Therefore, if investors' interest in higher-risk assets continues, it may be logical that they see high yield as a step that may provide a higher level of income than more conservative allocations, but without going directly into equities. A rotation into high yield could also be supported by continued economic growth and slightly accelerating inflation, as this combination may also push some investors out of high-quality bonds—due to their interest-rate risk—and into those with more credit risk.
Q. Considering that the yields in the high-yield bond market declined to historically low levels, what are the prospects for the asset class going forward?
Similar to other fixed-income asset classes, the absolute yields in the high-yield bond market have compressed significantly. Yet, relative to the debt of the highest credit quality, the high-yield market may still represent total return opportunities from a potential combination of income and capital appreciation.
Although the market's credit spread relative to U.S. Treasuries was 517 basis points (bps), as of early April 2013—narrower than the long-term average of about 592 bps—the spread remains well wide of the record-low level of 263 bps that was set in mid-2007.2 It is difficult to forecast whether high-yield credit spreads could approach that record level again, yet they may tighten further if investors regard them as compensation for the credit risk they may be taking. And the credit quality within the market has improved significantly in recent years, as high-yield borrowers refinanced their existing debt, which often involved extending the maturities on these obligations and lowering the borrowers' interest costs. These steps have contributed to an estimated default rate of less than 2.0% for 2013 and also for 2014, well below the long-term default rate of 4.2%, according to J.P. Morgan.
The long-term average credit spread of 592 bps relative to Treasuries also occurred when the 10-year Treasury note yielded an average of about 5.6% over the past 30 years, which indicates that high-yield bonds have, historically, provided additional yield spread of just over 100% of the yield of the 10-year Treasury note. And today with a 10-year Treasury yield of about 1.75%, high-yield securities offer nearly three times more yield spread than the yield of the 10-year note.3 While this yield could contribute to a positive real return for the asset class, it also could indicate further tightening in credit spreads if this historical relationship between the 10-year Treasury yield and high-yield credit spreads reverts to its mean.
Q. What are the implications from the strong issuance trends in the leveraged finance markets?
Investors' demand for high-yield securities has allowed companies to refinance their debt over the past several years, and that trend has continued in 2013, with more than two-thirds of the total year-to-date issuance (through early April) consisting of refinancing transactions.4 As companies have reduced their cost of capital, corporate profits—and, therefore, companies' ability to service their debt�has also improved. This could be viewed as a strengthening of credit quality from two angles, which is often a rarity in an environment of low interest rates that can often indicate an environment of stagnant corporate profits.
Investors' demand for yield can also lead to lower underwriting standards and an increase in corporate leverage. But by several measures, the market continues to appear far healthier than it did leading up to and at the height of the financial crisis. Indeed, only about 15% of the issuance in 2013 has been from lower-rated borrowers as of early April, and only 13% of the issuance has been used to finance acquisitions. In 2007, these offerings represented 36.2% and 51.5% of the market's total issuance, respectively.5
"Five Key Questions about High Yield, Part II," will address questions 4–5 on recent leveraged buyout activity and the United States' fiscal stagnation.
A Note about Risk: Investing involves risk, including the possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Fixed-income securities may also be subject to credit risk, which is the risk that the issuer may fail to make timely payments of interest and principal, and may be subject to call, liquidity, 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. 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. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. No investing strategy can overcome all market volatility or guarantee future results.
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.
An investment in a money market fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund.
Glossary of terms:
A basis point is one one-hundredth of a percentage point.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.