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High-yield: Riding out a rough period

High-yield bonds have tossed around in recent months, largely due to the same related factors behind the volatility flare-up in the stock market: a slowing global economy and the downside impacts of the U.S.-China trade dispute that many fear may get still worse.

That high-yield and equities would share a rough ride isn’t a surprise, given that both are risk assets correlated to corporate fundamentals. Within high-yield, the roughest ride has been in the riskiest segment – bonds rated CCC or below.  

But while the mood around high-yield may be more on edge, performance is holding up – for 2019, the ICE BofAML U.S. High Yield Total Return Index had gained around 11% as of late August. Bonds rated BB have been the key performance driver as investors sought to reduce portfolio risk.

High Yield Volatility Chart Revision


Yield spreads relative to investment-grade corporates have also been volatile lately. 

The yield gap between BBB and BB – where investment-grade and high-yield meet – began August at 70 basis points (0.7%), but in a matter of few days blew out to 125 bp after President Trump announced another yet round of tariffs aimed at China. Even with trade tensions persisting, BBB-to-BB spreads have narrowed to under 75 bp. 

Within high-yield’s rating tiers, however, spreads have widened – the yield difference between BB and CCC has expanded by nearly a percentage point in August. This suggests growing market worries about the economy following the Federal Reserve’s late-July interest rate cut. If the pessimism proves overdone, an opportunity could present itself should spreads within high-yield start to tighten again. 

Offering a short-term outlook for high-yield is difficult, perhaps even futile, in this uncertain environment. Our case for a strategic allocation to high-yield, however, is straightforward:

YIELD PICKUP: Over time, the income generated by a bond accounts for the lion’s share of its total return. Yield is hard to come by in this prolonged period of stubbornly low interest rates – this positions the high-yield segment as a valuable source of risk-adjusted income relative to other fixed-income offerings. 

RELATIVE RISK: The high-yield sector shares a number of key qualities with equities – the result is a positive performance correlation. On a risk/return basis, the high-yield index has over time captured most of the upside offered by the S&P 500, but with much less volatility (measured by standard deviation). 

DIVERSIFICATION: High-yield is a component of the fixed-income market, but it carries a low correlation to the higher-rated bonds that typically form core portfolio holdings – the long-term correlation to Treasuries is actually negative. While high-yield comes with more credit risk than other bonds, the sector tends to be less sensitive to changing interest rates.

 


The ICE BofAML US High Yield Master II Index measures the performance of U.S. dollar-denominated corporate debt rated below investment grade that is publicly issued in the U.S. market.

Bond ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).

Victory Capital, Inc. is a Registered Investment Advisor. The information in this article is based on data obtained from recognized services and sources and is believed to be reliable. Any opinions, projections or recommendations in this report are subject to change without notice and are not intended as individual investment advice. Not to be used as legal or tax advice.


©2019 Victory Capital Management Inc.

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