High Yield May Be Priced for Perfection

Sumit Desai: The high-yield bond market has staged an impressive rally so far in 2016 after bottoming in mid-February. Year-to-date, the average fund in Morningstar's high-yield bond category is up almost 12%, making it one of the best-performing taxable bond categories this year.

Digging a little deeper, it's interesting to see what's been driving these returns. The areas of the market that were hit the hardest in 2015 are also the best performing segments this year. Lower-rated CCC bonds are up 30% in 2016, and the energy sector is up 33% through the middle of October.

That said, even higher-rated BB and B rated corporate bonds are also up impressively this year, driven by investor appetite for yield and a generally benign view of the economy. Bullish investors would argue that high-yield bonds still offer an attractive absolute yield relative to other low-yielding areas like Treasuries. However, many also argue that the asset class is priced for perfection with little margin for error, as yields and spreads are currently below multiyear averages. Defaults outside of the energy sector are still relatively low but investors aren't currently being compensated for the risk of any uptick in bankruptcies in the future.

While the past few years were defined by turmoil in the energy sector, recent returns for high-yield bonds now seem to be driven by the market's outlook for interest rates. A rise in interest rates could also negatively impact the sector.

Valuations matter, and investors seeking stability and capital preservation are likely to be disappointed by high-yield bonds. It's important to view this asset class with a long-term lens and understand that the sector will continue to display higher correlations to equities than safer bonds like Treasuries.