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Attractive yields and fading concerns about higher interest rates have led to a surge of retail flows into high-yield bond funds in 2013, helping the asset class to a total return of 8.68% year to date (as of October 29), as represented by the BofA Merrill Lynch High-Yield Index. In fact, high yield has been enjoying a strong run for a while, producing double-digit returns in the index in three of the past four years, according to Bloomberg. [Of course, there is no guarantee that the high-yield market will perform similarly in the future, and returns during other periods may have been different or may have been negative.]
Does the recent performance mean that high-yield securities have run their course? A number of factors suggest there may still be room to run. First, the Federal Reserve has delayed the tapering of its bond-buying program. While some analysts expect tapering to begin early next year, others believe the relative sluggishness of the U.S. economy means that tapering won't begin until April 2014 or later, postponing the impact of higher rates.
1 BofA Merrill Lynch U.S. High Yield Master II Constrained Index.
2 BofA Merrill Lynch U.S. Corporate 'BBB'-rated 1-5 Year Index.
3 Barclays U.S. Aggregate Bond Index.
4 BofA Merrill Lynch U.S. Treasury Current 10-Year Index.
5 Barclays U.S. Treasury U.S. TIPS Index.
Past performance is no guarantee of future results. Please refer to "Important Information" regarding the economic indicator data in these charts and index information. The historical data are for illustrative purposes only and do not represent any specific Lord Abbett account 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. Performance during other time periods may be different or negative.
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. 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. 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. Treasury Inflation Protected Securities (TIPS) are Treasury securities that are indexed to inflation in order to protect investors from the negative effects of inflation. TIPS are considered an extremely low-risk investment since they are backed by the U.S. government and since their par value rises with inflation, as measured by the Consumer Price Index, while their interest rate remains fixed.
This means that investor flows into high-yield bonds could continue. High-yield bond funds have seen high daily inflows recently, according to J.P. Morgan, but there could be more to come. Many investors pulled out in May and June of this year after Fed chairman Ben Bernanke suggested that tapering could occur over the next several months. Some of those flows have returned, but they account for less than 60% of the $16.4 billion that left in May and June, according to J.P. Morgan.
Second, the moderate growth following the recession created something of a sweet spot for high-yield bonds, and this muddle-through economy is likely to continue. Weaker growth likely would have favored higher-quality bonds while stronger growth likely would have favored stocks. But with gross domestic product (GDP) chugging along at 2–2.5% per year, the economy has been strong enough to support speculative-grade companies, enabling them to make their interest payments and maintain their credit ratings. Low interest rates have helped as well, since many companies have refinanced their debt, thereby reducing their interest expenses.
Third, the amount of high-yield debt coming due in the near term has been reduced, lowering the chances of default (although there can be no assurance that the default rate will not rise). In refinancing their obligations, companies have reduced the amount due in the next two to three years, to a little more than 20% of their total debt, down from around 33% in fourth quarter 2009, according to J.P. Morgan.
Source: J.P. Morgan and Markit. Data as of 10/25/2013.
The historical data shown in the chart above are for illustrative purposes only and do represent any specific Lord Abbett mutual fund or any particular investment and are not intended to predict or depict future results. 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.
An increase in new issuance this year, including, in recent months, to finance acquisitions, raises the question of credit quality. The market, however, continues to be healthier than it was prior to the financial crisis. Most of the new debt year to date has been issued by companies in the higher tiers of high yield, and relatively little debt has been used to finance acquisitions, according to data from J.P. Morgan.
"As of late October, a little more than 18% of the issuance in 2013 has been from lower-rated borrowers, and only 18% of the issuance has been used to finance acquisitions," said Zane Brown, Lord Abbett Partner and Fixed Income Strategist. "In 2007, these offerings represented 36.2% and 51.5% of the market's total issuance, respectively, according to J.P. Morgan."
These strong fundamentals suggest that the chances of significant defaults are minimal. And, in fact, J.P. Morgan has forecast that defaults will remain below 2% annually through third quarter 2015.
A Note about Risk: The value of investments 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, and as interest rates rise, the prices of debt securities tend to fall. 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 date of a security, the greater the effect a change in interest rates is likely to have on its price. High-yield securities carry increased risks of price volatility, illiquidity, and the possibility of loss in the timely payment of interest and principal. 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. 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.
The BofA Merrill Lynch High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly traded in the U.S. domestic market.
The BofA Merrill Lynch High Yield Master II Constrained Index is a market value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. Issues included in the index have maturities of one year or more and have a credit rating lower than 'BB-'/'Baa3,' but are not in default. The BofA Merrill Lynch U.S. High Yield Master II Constrained Index limits any individual issuer to a maximum of 2% benchmark exposure.
The BofA Merrill Lynch U.S. Corporate 'BBB'-rated 1-5 Year Index is a subset of the BofA Merrill Lynch U.S. Corporate Index, which is an unmanaged index comprised of U.S. dollar denominated investment grade corporate debt securities publicly issued in the U.S. domestic market. The Barclays U.S. Aggregate Bond Index is an unmanaged index composed of securities from the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization.
The BofA Merrill Lynch U.S. Treasury Current 10-Year Index is an unmanaged index tracking the 10 year component of US Treasury securities.
The Barclays U.S. Treasury U.S. TIPS Index consists of inflation-protection securities issued by the U.S. Treasury. Securities must have at least one year to final maturity.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
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.