As we look toward 2017, we believe volatility will return to markets and what you don’t own will be as important as what you do.  It is time to play good defense and we will do just that while also capitalizing on the select value-based opportunities within today’s high yield market.  Click here to read our most recent market commentary, “Pricing Risk and Playing Defense,” in which we discuss our market outlook and corresponding investment strategy.

We ended 2016 with the 5-year Treasury yield at 1.93% and the 10-year at 2.45%, which is up a mere 20bps from where we ended 2015.  However, over the course of the year, it was a wild ride for Treasuries.  Yields fell as low as 0.94% on the 5-year and 1.37% on the 10-year in early July 2016 and spiked as high as 2.07% and 2.6%, respectively, in mid-December.¹  However, over that period from early July to the end of December when we saw rates climb more than 110bps, the high yield bond market had a strong performance, up 6.79% over that nearly six month period.²

The same cannot be said for other areas of fixed income.  Investment grade and municipal bonds both had negative returns over the same period in the face of rising rates.³

We have noted time and again in our writings, high yield bonds have historically performed well during periods of rising interest rates (as measured by Treasury yields), and the last six months again supports that (see our writings, “Strategies for Investing in a Rising Rate Environment,” “High Yield in a Rising Rate Environment,” and “The Election Impact on High Yield: Rates and Regulation” for further data on high yield bond market performance as rates increase).  However, with their higher correlation to Treasuries, lower starting yields, and higher duration, investment grade corporates, municipals, and other areas of fixed income are much more exposed to interest rate moves.⁴

Whether rates rise or not, we don’t see investment grade corporates or municipal bonds as an attractive investment option as we sit today.   Here you are faced with yields that are nearly half that of those offered by the high yield market and much higher interest rate risk given the average maturity profile is four or more years longer.

Looking back over the last 25-year history, the high yield bond market has had a 160-260bps return advantage over investment grade and munis, and we don’t see anything that would change that return advantage going forward.⁵

The gut reaction of investors seems to be to flee fixed income at the first hint of an increase in interest rates.  We would see this as a valid reaction for many areas of the fixed income market, but not for high yield debt.  With what we see as an attractive yield relative to other areas of fixed income, we believe high yield bonds have a place in investment portfolios going forward, irrespective of what happens with interest rates.

¹  The 2016 low was on July 5, 2016.  Other data as of 12/31/15 and 12/31/16.  Data sourced from U.S. Department of Treasury.

²  Bloomberg Barclays US High Yield Index covers the universe of fixed rate, non-investment grade debt.  Data for the period of 7/5/16 to 12/31/16 source Barclays Capital and U.S. Department of Treasury.

³  Bloomberg Barclays Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital). Bloomberg Barclays Municipal Bond Index covers the long-term, tax-exempt bond market (source Barclays Capital).  Cumulative returns presented, for the period 7/5/16 to 12/31/16.

⁴  Data as of 12/29/16, source Bloomberg and Barclays Capital.  Yield to Worst is the lowest, or worst, yield of the yield to various call dates or maturity date. Duration is the change of a fixed income security that will result from a 1% change in interest rate. The duration calculation is the modified adjusted duration for the indexes and Bloomberg calculated duration to workout for 5-Year and 10-year Treasury.

⁵  Data covers the period 12/31/1991 to 12/31/2016, data sourced from Barclays Capital.

The Federal Funds Rate and rates and US Treasury debt are independent of each other.  Federal Reserve action changes the Federal Funds Rate, which is an interbank lending rate.  This in turn can impact market expectations for rates and market psychology, and market forces (investor demand) in turn “set” the rates on US Treasury debt.  For instance, if investor demand lessens for Treasuries and they all of a sudden require to get paid more to hold Treasuries, this causes Treasury yields (rates) to increase.  In our own high yield market, “spreads” are priced off of comparable maturity Treasury rates, so it is these 5- and 10-year rates that are in focus for us.

With the most recent Fed chatter, we have seen the 10-yr move about 30 bps up from its 2016 lows of 1.37 bps in early July to 1.7 bps today, with an almost 30bps move in the 5-year Treasuries over this period as well.²  Yes, this renewed rate talk does bring an immediate market reaction in US Treasury rates; however, we don’t expect to see a sustained and significant spike in the longer-end 5-, 10-and 30-year rates, even if/when the Fed takes further action in raising the Federal Funds Rate over the next year.  We would expect the shorter-end of the curve to be impacted by Fed action, but we’d expect the longer-end of the curve to continue to be constrained by a number of factors, including the following:

• Global Growth: We are in the midst of a weak global demand outlook and a weak global economic environment.  China has been slowing, quantitative easing is still underway by the ECB hoping to get things going in Europe, and the Bank of Japan has been even more aggressive in their intervention.  Demand worldwide is tepid, impacting corporate profits and demand her at home.  Retail sales, industrial production, and GDP growth have been anything but robust here in the US.  In short, we certainly don’t have a strong economy that the Fed needs to temper and that the strong “data” the Fed looks to may be hard to come by in order to make much of a rising rate argument.  These longer dated Treasuries certainly take their cues from the data as well.
• Global Rates: We expect that historically low, and in some cases negative, rates on sovereign debt throughout much of the developed world compared to our rates and economy will cause a continued demand for much higher yielding US Treasuries.  For instance, investors are in essence paying to have their money held for 10-years in Japan, Switzerland, and Germany.  Much of the rest of Europe has rates sub 0.5%, while the UK, even if the face of all of the Brexit uncertainty has rates under 1%.
• Global Demographics: The population is aging and with that investors will become more and more focused on capital preservation and income generation causing them to rotate from equities into fixed income.  Additionally, as pensions focus more on liability driving investing (matching assets/income with upcoming liabilities/payouts), stability and calculated income will be key. We are already in the beginning stages of this and expect it to continue (see our pieces “Zero Sum Game” and “Of Elephant and Rates”), causing a demand for fixed income assets in the years and decades to come.

While we may see some continued near-term volatility in the 5- and 10-year rates on this resurgence of Fed-speak, we ultimately don’t expect the see a sustained upward swing in these yields.  We expect that the yield curve will flatten and in this low yield environment investors will continue to search for yield, and we believe that with the yields offered by high yield bonds, this remain an asset class investors should consider as they look for this yield.

¹  Based on US Department of Treasury data, as of 12/31/13, 12/31/14, 12/31/15, and 9/16/16.

²  2016 low on 7/5/16 versus rate as of 9/16/16.

High-yield funds reported outflows for the week ending June 15^th totaling $1.8 billion as market sentiment turned negative. This was the largest weekly outflow since the week ended May 11^th. Primary issuance stalled over the past week with just nine deals for $5.395 billion pricing versus over $12 billion the prior week, which was the busiest week since November.

The Bank of America Merrill Lynch High Yield Index monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.  Index data sourced from Bloomberg. BAML HY represents the index yield for the designated date, while return/change represent the index return for the period ending date. Yield referenced is the yield-to-worst and spread referenced is the spread-to-worst.

The Bank of America Merrill Lynch High Yield Index monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.  Index data sourced from Bloomberg. Yield referenced is the yield-to-worst and spread referenced is the spread-to-worst.