Between the market low in February and the July peak, high yield bonds rallied roughly 15%, according to Bloomberg data. After adjusting for risk, the bounce in high yield was even greater than the rally in stocks. More recently, however, high yield has started to fade. Although interest rates remain low and the search for yield continues, after such a strong rally it is worth asking: Is it time to start selling high yield?
The easy money boat has sailed
The case for high yield rests largely on the fact that it remains one of the few asset classes left that can offer a greater than 5% yield. Spreads (the difference between the yield of a high yield bond and a U.S. Treasury) have come in considerably since the winter lows. But relative to Treasuries, high yield still provides a spread of around 540 basis points (5.4%), close to the long-term average (source: Bloomberg). It is true that if you strip out energy companies, spreads are a bit tighter. This suggests that while high yield pricing is not particularly daunting, the easy money has already been made. Historically, the best time to buy high yield is when spreads are wide, such as earlier this year when spreads briefly climbed over 800 basis points (source: Bloomberg).
An improving economic outlook is a plus
In short, valuations can be described as reasonable but not cheap. In that case, it is important to consider the economic outlook. More than most other segments of the fixed income market, high yield typically performs better when the economic outlook is improving. For example, high yield returns have been positively correlated with quarterly changes in my preferred leading indicator, theChicago Fed National Activity Index (CFNAI). On this score the outlook for high yield looks a bit better. While still suggesting lackluster growth, the CFNAI recently moved back into positive territory, signaling the expansion can continue.
Average valuations and a decent if lackluster economy probably equate with modest but positive returns. In the current environment modest may be good enough. The reason comes back to yield: Although current yields are low by historical standards, they look more compelling in the context of an ever shrinking pool of high yielding assets.
Still has a place in most portfolios
Even if you assume some widening of spreads and a lower total return, there is still a case to be made for including high yield in portfolios. Using the BlackRock Investment Institute’s five-year capital market assumptions of 3.6%, which take into account how we think current economic and market conditions will play out in the medium term, traditional portfolio construction methods suggest a 5%-10% allocation in all but the most conservative portfolios. The reason why: Volatility is low compared to stocks, and yields are generous compared to other types of bonds.
What are the caveats?
The big one is the economy. With growth stuck below 2%, investors are not being paranoid in worrying about the next recession. Should the economy start to contract, high yield would likely trail investment grade and government bonds.
Another risk factor is oil. Given exposure to smaller, more speculative energy companies, for most of the past year high yield has been trading in line with oil. The correlation has weakened a bit in recent months, but if oil remains below $40 a barrel, investors are likely to refocus on the solvency of smaller energy companies.
Bottom line: While the risks are real, in a world of slow but steady growth high yield still has a place in most portfolios.