High-Yield State of Mind

A version of this article was originally published in the December 2017 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

Despite a few hiccups along the way, high-yield bond funds have been on an impressive run since the 2008 financial crisis. From April 2009 through November 2017, the median high-yield bond fund returned 10.9% annualized. By comparison, the Bloomberg Barclays U.S. Aggregate Bond Index (often used as a proxy for a core investment-grade fixed-income allocation) only returned 4.0% annualized over the same period.

Spreading Holiday Jitters But what are the prospects for junk bonds going forward? One way to answer that question is to look at the spread (or difference in yield) between high-yield bonds and U.S. Treasuries. The spread is a simple, short-hand way of assessing high-yield bond valuations. All other things equal, when the spread is narrow, high-yield bonds are relatively expensive. When it widens, they are relatively cheap.

On Dec. 8, 2017, the spread between junk bonds and Treasuries stood at just 3.63 percentage points. This spread has reached lower levels over the past 20 years--it hit 2.41 in June 2007, immediately preceding the financial crisis--but not very often. Until very recently, the post-crisis low was 3.39, reached on June 1, 2014, right before a commodity sell-off thrashed junk bonds and sent the spread soaring to a recent high of 8.87 on Feb. 11, 2016. Since then, high-yield bonds have been on a tear, with the median fund returning 14.3% annualized from Feb. 12, 2016, to Nov. 30, 2017. Following that impressive run, the spread hit a new post-crisis low of 3.38 on Oct. 24, 2017. High-yield bonds sold off very slightly in the weeks that followed but appear to have stabilized as of this writing.

The long-term average spread is roughly 5.7 percentage points, so current levels are well below that norm. As a result, managers are on edge and concerned about a potential sell-off. Many managers with whom we have recently spoken are taking the opportunity to increase the credit quality of their portfolios and swap into what they view as more liquid bonds.

If their prospectus allows them, some managers are also increasing their allocation to bank loans. These loans, which pay a floating coupon and are typically junk-rated, are often used by high-yield managers to increase the defensiveness of their portfolios. The securities have historically held up better than high-yield bonds during credit sell-offs and generally have higher recovery values in the event of a default. However, their effectiveness is reduced by at least two factors. Loans are frequently called at par, which reduces potential upside. Meanwhile, the defensive properties of bank loans stem from their seniority in a company's capital structure, which gives them a priority claim on a company’s assets in the event of a bankruptcy. With a significant proportion of new loans issued by companies with loan-only capital structures, this advantage is less pronounced.

Making Moves

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However, there is a counterargument to these managers' concerns. Corporate America is arguably at its strongest since the financial crisis, with strong revenue and earnings growth and record profit margins. Demand also remains strong, especially from foreign investors who are looking to squeeze out extra yield wherever they can find it. This means that, while the current spread level might make investors nervous, there are no obvious catalysts that could trigger a sell-off, and default rates could remain relatively low. High-yield bonds could continue to rally, but investors should beware that there may be limited upside left in the current market.