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High-Flying High Yield, for Now

Looking under the hood of high-yield bonds' recent performance.

High-yield bond funds are in the news once more given this year’s terrific performance run. From Jan. 1, 2019, through May 29, 2019, the high-yield bond Morningstar Category posted a 7.3% median return, while the ICE Bank of America-Merrill Lynch U.S. High Yield Index returned 7.8%. For comparison, the Bloomberg Barclays U.S. Aggregate Bond Index--the common proxy for investment-grade intermediate-term bond funds--returned 4.3% over the same period.

This rally stands in stark contrast to the sharp sell-off in the fourth quarter of 2018, which was driven by the Fed’s decision to continue raising rates, along with ongoing concerns regarding the trade negotiations between the United States and China. While the sell-off began in the equity markets, it eventually spilled over into the credit markets, particularly in the month of December. From October through December, the high-yield bond category lost 4.4%, nearly half of that coming in December alone. From Oct. 1, 2018, high-yield spreads (the difference in yield between high-yield bonds and U.S. Treasuries) widened from 322 basis points out to 544 basis points on Jan. 3, 2019.

Then on Jan. 4, 2019, Fed chairman Jerome Powell indicated that the Federal Reserve would be patient regarding future rate hikes and unwinding its balance sheet. Investors took these statements to mean a dovish shift in Fed policy, and since then both the credit and equity markets have roared back to life. Since Powell’s statements, spreads have tightened back to 419 basis points as of May 28. The change in tone from the Fed was so significant that, following Powell’s statement, J.P. Morgan raised its 2019 return target for high-yield bonds up to 8% from 3%. Without the pressure of rising interest rates, the relatively high coupon paid by high-yield bonds--higher than bank loans and most forms of securitized credit--would be the primary return driver.

Of course, high yield has already almost matched that full-year target, and spreads have tightened most of the way back to the recent lows. Indeed, the current spread is near the low end of the historical range. This indicates that spread tightening is less likely to be a major driver of returns in the near future, possibly capping total return potential.

One interesting quirk to note is that BB rated bonds (the highest-quality part of the high-yield market) led the rebound for the first three months of the year, followed by B rated bonds, while the CCC rated cohort brought up the rear. This is the reverse of what usually happens during credit rallies. That dynamic shifted in April, with CCC rated issues again taking the lead, but the phenomenon persisted long enough to create some interesting performance stories.

Indeed, that is one explanation for why Vanguard High-Yield Corporate VWEHX (with a Morningstar Analyst Rating of Silver) has outperformed peers so far in 2019. The fund, which often sticks to the higher-quality parts of the high-yield market, returned 8.3% year-to-date through May 29, 100 basis points above the group norm. Vanguard High-Yield Corporate typically outperforms during credit sell-offs and underperforms during rallies; this time, it managed to hold up well in late 2018 while also beating more than 80% of peers in the 2019 rally.

The Fed's pivot also affected high-yield funds that hold sizable bank loan allocations. Because loans are no longer benefiting from rising interest rates, their floating-rate coupons are less attractive than the higher fixed-rate coupons on bonds. This has driven investor sentiment, and bank loan prices have not recovered to the same extent as bond prices in 2019. Fund such as Bronze-rated Artisan High Income ARTFX, Neutral-rated Metropolitan West High Yield Bond MWHIX, and Neutral-rated Nuveen Symphony Credit Opportunities NCOIX have all been weighed down by this dynamic.

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