Why High Yield Still Has a Role to Play
A darling asset class of this bull market has been U.S. high yield debt, as many searching for income in a low-rate world have turned to these higher-yielding bonds. According to Bloomberg data, on an annualized basis through July 31, the Barclays U.S. High Yield two percent Issuer Cap Index has gained 14.9 percent since December 2008, trailing only the S&P 500 Index (up 16.1 percent) in performance.
However, with a Federal Reserve (Fed) rate hike on the horizon for later this year and universal acceptance that it’s late in the current credit cycle, some investors are considering abandoning the asset class. The fear is that outflows from high yield could continue, putting it under pressure, and some have even speculated that high yield debt may be the next “Big Short.”
Given all this, high yield may still have a portfolio role to play for investors. Here’s why.
1. THERE’S VALUE THERE.
It’s hard to argue that high yield is cheap. Spreads (yield minus the yield of comparable U.S. Treasuries) are currently 575 basis points (bps), down from 1,930 bps in 2008, according to Bloomberg data.
But while high yield certainly isn’t cheap, the recent widening of spreads has returned some value to the asset class. Today’s high yield spread is still 135 bps above pre-2013 Taper Tantrum levels and 175 bps above the tightest post-crisis levels reached in June 2014, according to Bloomberg data. Looking forward, since the Fed has telegraphed its intent to normalize policy rates, we don’t expect another Taper Tantrum, and current spreads appear to offer fair compensation, at least on a relative basis.
2. AND ATTRACTIVE YIELDS.
Although volatility could persist, yields are attractive relative to other yield-generating instruments. Also, the current incremental pickup in yield relative to volatility looks reasonable as compared to that of fixed income alternatives.
3. FUNDAMENTALS REMAIN ATTRACTIVE.
Defaults in the high yield space still remain low, currently sitting at 1.9 percent, well below the 25-year average of 3.6 percent, according to J.P. Morgan Credit Research as of July 31.
It’s also important to remember that high yield has actually performed quite well in rising rate periods, as the chart below shows. It also tends to perform well in a positive growth environment, holding a 0.76 correlation with U.S. PMI, according to our analysis using data from Bloomberg. While we don’t expect a massive acceleration in growth, we also don’t foresee a recession. The environment we expect—slow, but positive growth—should actually be a favorable one for the asset class, maybe even relative to equities.
To be sure, the asset class is not without its risks. Energy and mining sectors represent 20 percent of the Barclays Capital High Yield Index, according to Bloomberg data as of July 31. Yet surprisingly, oil prices can explain 70 percent of the movement in spread levels of the entire index over the last year, our analysis shows.
High yield debt issuance has also continued to reach record levels, though we expect there will not be a rush to issue once the Fed moves on rates. In addition, high yield shares certain characteristics with stocks, so investors who are already heavily exposed to equities should consider a more modest allocation. In other words, allocation to high yield needs to be viewed in the context of an entire portfolio. Finally, as we see higher levels of stock market volatility, high yield volatility is likely to rise as well.
But here’s the bottom line: While there’s no denying the above risks, high yield’s positives still argue for some allocation in portfolios, particularly for investors with aggressive income objectives.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.
Terry Simpson, CFA, is a Global Investment Strategist for BlackRock. He contributed to this article.