You may have read some scary headlines on high-yield bonds recently. We’d like to take a moment to update you on the situation and provide our perspective. First a little background. High-yield bonds are debt securities issued by companies with credit ratings below investment-grade. These bonds are commonly called “junk bonds” because of the weaker balance sheets and growth prospects of the companies that issue them. As a result of increased default risk, investors typically demand higher interest rates on these types of bonds to compensate for the additional risk they take on. When things are going well, high-yield or junk bonds can deliver above-average interest payments and price appreciation. When things are not going well, investors can experience sharp price declines and some companies may even default on bond payments. In a nut shell, higher reward comes with higher risk.
Many advisors, including Parsec, include a modest amount of high-yield bonds in client portfolios. Junk bonds are considered an asset class and can improve the diversification of a portfolio because they have lower correlations to regular bonds and even stocks. This means when regular bonds are flat or down, high-yield bonds could actually rise. The same goes for stocks – high-yield bonds and equities do not always move in the same direction, which confers some diversification benefits.
In addition to diversification benefits, junk bonds have historically delivered healthy returns. The group tends to do well in the early years of an economic expansion when tight credit starts to loosen and company balance sheets improve. On the flip side, high-yield bond performance becomes more volatile as an economic expansion starts to slow down and the spread between higher-quality bonds and junk bonds widen. This indicates investors once again require more return to hold these higher-risk assets.
Earlier this year, interest rate spreads – the difference between high quality bond interest rates and low quality or “junk” interest rates – started to widen as energy company profits came under pressure and debt default rates ticked higher. Since May 2015 through mid-December, high-yield bond prices have fallen over 12%*. However, on a total return basis, the group is down about 8% as higher coupon payments were a partial offset. While debt default rates on speculative-grade companies are below the 20-year average of 4.3%, at around 2.8%, they’ve jumped from 1.4% a year ago due to falling commodity prices that negatively affect profits**.
As high-yield returns tumbled over the summer, many investors ran for the exits. Unfortunately, diminished bond liquidity following the 2008-2009 financial crisis made redeeming shares difficult for some. Regulations that strengthened the banking and financial systems via higher capital requirements and reduced leverage have had the unintended side-effects of raising costs for banks and primary dealers to hold fixed income inventory. With lower inventory levels, these critical market makers are less able to provide liquidity in the debt markets. This was highlighted recently when investment firm Third Avenue froze investor redemptions in its high-yield fund (which is not a Parsec holding) due to liquidity constraints. The Third Avenue fund was heavily invested in some of the lowest-ranked credit bonds, which exacerbated the management team’s ability to find willing buyers. In the end, Third Avenue chose to freeze investor redemptions for one month.
The Third Avenue situation is unusual, but does it reflect deeper issues for the high yield space? Our view is that current U.S. economic expansion is maturing, which suggests higher credit spreads and potentially more volatility (including downside risk) for the group. At the same time, falling commodity prices and a strong dollar are headwinds for high-yield. That said, U.S. jobs growth remains robust, the housing market continues to advance, and consumers are the healthiest they’ve been since before the Great Recession. The recent Federal Reserve interest rate hike echoes our sentiments that the U.S. economy is on healthy footing.
While high-yield may see more downside, we believe investors are becoming more discerning after years of indiscriminate investing across high and low-risk asset classes alike. This is a good thing. It means that fundamentals, and not accommodative monetary policy, will once again drive asset returns. Although high-yield bonds may face more headwinds in the near-term, our focus on higher-quality, higher-liquidity, high-yield debt should help us better weather a difficult environment.
Despite potential high-yield headwinds, we continue to recommend that clients remain fully invested. This is based on our experience that market timing is a losing game, as asset class leadership can change sharply, and often without warning. The historical record has shown that through various market cycles, both stocks and bonds have out-paced inflation over the long-term. As a result, we recommend investors stick with their high-yield holdings.
*The BofA Merrill Lynch US High Yield Index
**S&P 500 data
Carrie A. Tallman, CFA
Director of Research