For intermediate-term bond funds, a healthy allocation to credit has been a boon to recent performance. The Bloomberg Barclays Investment-Grade Corporate Index gained 6.3% annualized, in 2016 and 2017, while the Bloomberg Barclays High-Yield Index generated an explosive 12.2% annualized during the same period. Compared with the far more modest 3.1% of the broad Bloomberg Barclays U.S. Aggregate Bond Index, exposure to credit was a discernable performance advantage.
Today, managers are worrying that the credit party is about to end. The markets are starting to become more volatile as some head for the exits. In January 2018, the payoff for taking credit risk reached very low levels so that managers felt there was little reward to taking credit risk. The average option-adjusted spread of the Bloomberg Barclays Corporate Investment Grade Index, a measure of the yield premium earned over a comparable U.S. Treasury, tightened to 85 basis points by January, a level that was last seen in 2007. S&P estimates that the number of highly leveraged corporates has grown to 37%, which is 5 percentage points higher than prior to the financial crisis. Yet default rates remain low. Add to this situation more-positive economic indicators and a Federal Reserve that responds by raising interest rates at its fastest clip in a decade, and there are plausible reasons for portfolio managers to question the endurance of this credit rally.
Emory Zink does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.