- The market is quite different than just a year ago.
- There have been two rate increases in the last six months, with two more possible this year.
- High yield bonds can offer an opportunity for yield in a tightening market.
Strong 2016 performance and a sharp rally in credit spreads have prompted some investors to take a cautious view of high yield bonds.
However, we believe this asset class remains attractive as part of a fixed income allocation, particularly as the US Federal Reserve looks to raise interest rates. The key is to approach the asset class thoughtfully.
The Market is changing
The surprise election of Donald Trump was a game changer. While many details of this new administration are still uncertain, the general direction is clear. The positives of pro-growth tax cuts, regulatory rollback, and infrastructure spending have to be weighed against a deleterious impact on global trade. Monetary policy remains generally accommodative. However, a shift in the Fed’s “dot plots” and more hawkish rhetoric from many Federal Open Market Committee (FOMC) members could indicate a path to higher Treasury rates that is not as far off as recently thought.
Why consider high yield?
As the Fed plans to embark on its next interest rate tightening cycle, investors in traditional fixed income assets are bracing for a prolonged period of underperformance. Zero-interest-rate policy over the last several years has left many core fixed income portfolios with little yield cushion to absorb rising benchmark rates. Duration risk for bellwether core benchmarks, such as the Bloomberg Barclays US Aggregate Index, has also drifted steadily higher. The result is that portfolios overexposed to highly interest-rate-sensitive segments, such as U.S. Treasuries, U.S. agency bonds, and mortgage-backed securities, may be even more vulnerable to principal losses than they were during past rate hike cycles.
As cycle change, risks change
To help diversify portfolio duration risk and strengthen yield curve positioning, investors may consider a high yield bond allocation. Credit spreads are still more than double those of investment-grade corporates and mortgage-backed securities, with far less interest rate sensitivity than either of these segments.1 Moreover, earnings estimates among the high yield issuer base are indicating marked improvement in 2017 as companies get a double benefit from the improving domestic economy and the potential boost of the domesticfocused fiscal policy of the new administration. Further, high yield default rates should begin to fall aggressively in the second half of 2017 to a more typical 3% – 4% range, due to an improved backdrop for commodity-related credits.
However, solid fundamentals are largely reflected in valuations across all asset classes. While default rates are forecasted to trend lower, valuations leave little cushion to absorb periods of heightened volatility. Given the policy uncertainty related to the new Trump administration, a busy 2017 election calendar in Europe, and the prospect of a more active Fed, some vigilance is warranted.
High Yield Bond Spreads Have Tended to Absorb Most Treasury Increases
Performance when five-year U.S. Treasuries rose 70 bps or more in three months. Source: JPMorgan as of 12/31/2016. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Past performance is not indicative of future results. Any views represent the opinion of the manager and are subject to change.
High yield bonds have prevailed in past rate hike cycles
To illustrate the impact of U.S. Treasury yield increases on high-yield bonds, consider how the asset class has performed during previous periods when five-year U.S. Treasury yields increased 70 basis points or more in three months. We examined each of these occurrences over the past 25 years. High yield bond spreads absorbed 80% – 100% of the U.S. Treasury yield increase, with returns moderately affected during the period of interest rate volatility. Positive returns resumed as rate volatility typically abated over the subsequent three-month period. Consider the fourth quarter of 2016, when the yield-to-maturity on the five-year Treasury note rose from 1.15% to 1.92%, a difference of 77 basis points. During this period, high yield absorbed this Treasury move as spreads rallied 71 basis points, which provided for a total return of 1.75%.
Higher Rated High Yield Credits Have Delivered Better Risk-Adjusted Returns
Source: Bloomberg Barclays, as of 12/31/2016. Past performance is not a guarantee of future results. Sharpe Ratio: a measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment. Standard deviation: a measure of the degree to which a fund’s return varies from its previous returns or from the average of all similar funds, generally expressed as a percentage. The larger the standard deviation, the greater the likelihood (and risk) that a security’s performance will fluctuate from the average return. The larger the standard deviation, the greater the likelihood (and risk) that a security’s performance will fluctuate from the average return. Ratings shown are the middle ratings of Moody’s, Fitch and S&P combined, as compiled by Bloomberg Barclays.
Why manager style and size have become increasingly important
As rates begin to normalize over the next several years, we expect security selection and alpha to play a much greater role in high yield bond portfolio returns than sector rotation and beta. The added gains and downside protection a skilled manager can deliver can be considerable, in terms of capturing both opportunistic capital appreciation and greater compounding opportunities through consistently higher income generation.
To help assess an investment manager’s ability to deliver stable alpha and limit default loss, investors can evaluate:
- Whether the investment process is disciplined and repeatable. Securing steady outperformance in high yield requires a consistent investment process that properly balances risk and return. Managers should have consistent track records of being appropriately compensated for the portfolio’s credit risk.
- The manager’s experience across full credit cycles. Understanding when and how to shift portfolio risk as the credit cycle evolves can be crucial. Managers should have proven experience navigating both favorable and difficult past markets.
Overall, we believe the case for including high yield bonds in a fixed income portfolio remains compelling due to better resilience in the face of rising interest rates.
1 Source: Barclays US Corporate HY Index as of 12/31/2016
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Past performance is not a guarantee of future results. The opinions expressed are those of Ivy Investment Management Company and PineBridge Investments and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through May 2017, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.
Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. International investing involves additional risks including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. These and other risks are more fully described in the Fund’s prospectus.
Alpha is defined as the excess returns of a fund relative to the return of a benchmark index. Beta is defined as the measure of volatility of an investment in comparison to the market as a whole.
The Fund is managed by Ivy Investment Management Company (IICO) and subadvised by PineBridge Investments. IICO oversees the Fund’s investments and its business operations. PineBridge chooses the Fund’s investments and provides related advisory services.
The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency). The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded. It is not possible to invest directly in an index.
IVY INVESTMENTS℠ refers to the financial services offered by Ivy Distributors, Inc., a FINRA member broker dealer and the distributor of IVY FUNDS® mutual funds, and those financial services offered by its affiliates.