After a rough start to the year, following a negative 2015, the high yield bond market has reversed course and posted strong returns year-to-date, now up 15.0% through the end of August1. This compares to a return of 7.8% for the S&P 500 index2. Is the run over for high yield? We certainly don’t think so.
A few things to keep in mind. Yes, some of the strong return in the high yield index (and likely the S&P 500 too) has been energy induced. As we have previously noted, energy and commodities are a notable portion of the high yield index and as energy recovered off the mid-February lows, we have also seen high yield recover. However over the past few months we have seen oil prices range bound, though volatile within that range, and high yield still going up even when energy prices were going down (see our piece “Breaking the Correlation”). Looking at just the last three months, the high yield market has still outperformed equities with the Barclays US High Yield Index up 5.8%3 and the S&P 500 up 4.1%4, all the while oil prices (WTI) were down nearly 9%5. And looking at the YTD performance of high yield bonds of 15.0%, this market is still up 11.7% excluding commodities6. So certainly energy prices aren’t the only driver of return for high yield.
One of the biggest current draws we see in high yield is the yield advantage we see it offering versus other areas of fixed income and equities.7
As demand and prices for high yield bonds have increased so far this year, we have seen the yield come in; however, the yield offered by high yield bonds still far surpasses that offered by other asset classes—twice that offered by investment grade, three times the (dividend) yield offered by the S&P 500 and nearly four times what is offered by the 10-year Treasury.
For the naysayers and those that question whether there is more room for the high yield market to go higher from here, it is important to keep valuations in mind. In terms of valuation, it is well known that equity valuations are currently high relative to history so don’t appear to be cheap by anyone’s measure, while high yield bond spreads are currently right about at the 20-year median levels.8 Also, on the default side of things, we are starting to see defaults decline in the most recent month after accelerating over the past year. As we have noted in the past, default rates have increased this year by and large due to energy and other commodity related defaults. Excluding these commodities, default rates are currently only 0.5% for the rest of the high yield market versus historical high yield default averages near 3.5-4%.9
Potential Fed action is an overhang on markets, but even if the Fed were to undertake another rate hike in the coming months, we don’t expect that to tangibly mean much for high yield bonds. We would expect high yield bonds to weather an increase better than equities and we’d also expect any rate move to be very small. The Federal Reserve is being anything but aggressive with their interest rate increases. We saw the first rate increase in nearly a decade last December, and even if they were to do another rate hike in September, which seems doubtful, it would have been nine months since the last hike. We all know they want to raise rates, but the economic data is forcing them to be extremely measured in doing so. By their reading, they have seen some improving data, so maybe another rate increase in justified in their minds, but we don’t see much more beyond that in the near- to medium-term. We remain in an environment of a weak global economy and negative yields through much of the rest of the developed world, which we believe will ultimately constrain domestic rates (Treasury yields) no matter what small movements the Fed makes in the Federal Fund Rate. It’s these Treasury yields, primarily the 5- and 10-year, which are more relevant for high yield bond investors, not the Federal Funds Rate. We think it is just as likely for the 10-year Treasury yield hit 1% as it is 2%…there are just so many global pressures that we wouldn’t be surprised to see the 10-year Treasury yield take another step down, no matter the “Fed speak.”
So as we enter September and investors look where to position themselves for the rest of the year, we believe the high yield market is an attractive area to consider. Valuations appear reasonable in the face of low defaults in much of the market (outside of commodities) and yields double and triple some of those available from other asset classes.
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