Bonds Commentary

Pass on Passive - In High Yield Anyway

April 2018

After holding up relatively well during the initial equity sell-off in late January/early February, high yield bonds finally succumbed to selling pressure over the back half of March, with the Bloomberg Barclays U.S. High Yield Index falling 0.60% during the month. It’s notable that the High Yield Index had fallen only 0.86% year-to-date through March, holding up far better than the -2.32% total return of the Bloomberg Barclays U.S. Corporate Index (investment-grade corporate bonds) and the -1.46% total return generated by the Bloomberg Barclays U.S. Aggregate Bond Index overall. Due to higher coupons/yields, high yield bonds have less interest rate sensitivity than their investment-grade brethren, leaving them relatively less impacted by oscillations or shifts in the Treasury yield curve. These bonds do carry either a below investment-grade rating or are unrated by Moody’s, S&P, etc., implying that issuers of these bonds are often in some manner of financial hardship – hence, the higher yield to attract buyers. In the case of high yield bonds, issuers often have little margin for error, and an economic downturn, or simply stagnation, can weigh heavily on an issuer’s ability to make required interest payments, increasing the probability of default.

High yield bonds have had a strong multi-decade run, with the Bloomberg Barclays U.S. Corporate High Yield Index posting an annualized return of 8.39% from 1990 through the end of March. But it’s been far from smooth sailing at times. From the start of the Financial Crisis on February 27, 2007, the day Freddie Mac announced it would no longer buy risky subprime mortgages, through March 6, 2009, the bottom in the S&P 500 at 666 – just over 2 years – the High Yield Index posted an annualized -14.5% return. This is just one extreme example, but worthy of remembering nonetheless. Credit has been, and remains expensive, broadly speaking, making it highly susceptible at present to bouts of market indigestion surrounding risks of all ilk’s – geopolitical, economic, or otherwise – leaving us less than sanguine surrounding potential outcomes from index-linked exposures to the high yield space over the intermediate-term.

The first quarter was marked by short-term interest rates marching higher, while the belly and long-end of the yield curve spiked higher, then stair-stepped lower to end the quarter – ultimately culminating in a significant flattening of the yield curve. We took a look at the two largest high yield exchange traded funds (ETFs) – JNK and HYG – relative to the actively managed high yield peer group during 1Q18. With high yield bonds, broadly speaking, stacking up relatively well during the quarter versus investment-grade bonds, one might have expected index-linked vehicles to fare reasonably well, but that’s not the case. Both JNK and HYG finished the quarter in the bottom third out of a sample size of 194 funds, underperforming the peer group median return by 0.72% and 0.28%, respectively, despite charging lower fees than the majority of actively managed peers. We’ve long favored active management in the high yield space, and after a prolonged period of spread tightening, we believe an active approach is more crucial at this juncture to achieving a positive outcome than has been the case for some time. We maintain a neutral stance on high yield relative to our long-term strategic target due to the pick-up in yield, or carry, relative to investment-grade bonds, and our positive outlook on the U.S. and global economies leading to continued low defaults in the space. Investor sentiment and risk aversion can weigh heavily on high yield even when there is little/no underlying fundamental change. High yield investors should stay the course and avoid overreacting to news flow.

Source: Bloomberg, Morningstar


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