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Few asset classes cause as much investor confusion
as high-yield bonds. Because they are in fact
bonds, many investors may expect these investments
to provide safety during times of market distress.
However, unlike Treasury and other high-quality bonds
that typically fulfill this role, high-yield corporate
bonds tend to be correlated closely with equities and
are more likely to suffer losses in sympathy with
stocks during market sell-offs. The stunning collapse
of
Third Avenue Focused Credit
TFCIX
in Decem-
ber
2015
also did little to ease investor concerns about
high-yield bonds, though we continue to believe
that situation was an isolated incident and that traditional
high-yield bond funds are unlikely to experience a
similar fate.
There’s no denying that
2015
was a difficult year
for even the most conservatively run funds in the high-
yield bond Morningstar Category. Over the year,
the Bank of America Merrill Lynch U.S. High Yield
Master
II
Index fell
4
.
6%
, compared with a positive
1
.
4%
for the S
&
P
500
and a
0
.
6%
gain for the Barclays
U.S. Aggregate Bond Index. Most of the pain came
from
CCC
rated bonds, which land at the lower-quality
end of the high-yield market, and energy and other
commodity-related issuers. Higher-quality fare, bonds
with
BB
and B ratings, performed better on average
but were not immune to losses. Sharp outflows from
the sector coincided with this sell-off.
Early March gave the sector a bit of a reprieve as
inflows turned sharply positive and high-yield bonds
rebounded sharply. Still, the outlook remains mixed.
Bullish investors suggest that high-yield bonds rarely
post two consecutive calendar years of negative
returns, so the poor returns of
2015
would indicate the
asset class is due for a rebound. And, while spreads
narrowed recently to around
674
basis points over Treas-
uries—compared with a post-financial-crisis high of
887
basis points on Feb.
11
,
2016
—the sector’s
8
.
3%
yield still appears attractive relative to other fixed-
income asset classes. What’s more, most sectors of
the economy outside of energy and other commodities
seem to be doing just fine, and most of the risk in
commodity sectors may already be priced into the bonds.
On the other hand, there are some obvious risks lurking
that investors should be aware of. The energy sector
remains a wild card, and the viability of many energy-
sector bonds will depend on oil prices, which are
largely unpredictable; widespread defaults are still a
strong possibility in this sector. Further, valuations
outside of energy are less attractive. While the overall
high-yield market yields
8
.
3%
, yields excluding
energy, metals, and mining are closer to
7%
. And, while
the U.S. economy seems to be chugging along,
individual companies within the high-yield sector still
present idiosyncratic risk. For example, companies
like
Sprint
S and
Valeant
VRX
(two of the largest issuers
in the market) both face company-specific issues
that threaten the value of their bonds.
While high-yield bond funds won’t help you diversify
away from equities, income-generation and long-
term return potential still make them an interesting
choice to include in a well-diversified portfolio.
Over the past
10
years through February
2016
, open-end
high-yield bond funds returned about
5
.
6%
annualized
versus
6
.
8%
for the S
&
P
500
, but high-yield bonds gener-
ated better risk-adjusted returns because of about
33%
less volatility than stocks. Given the asymmetric
risk in the sector (limited upside and unlimited down-
side), investors looking for high-yield exposure with
less default risk and volatility should consider man-
agers with a record of focusing on the higher-quality
portion of the market. Across high-yield bond funds in
the Morningstar
500
,
Vanguard High-Yield Corporate
Fund
VWEHX
, with a Morningstar Analyst Rating of
Silver, and Bronze-rated
PIMCO High Yield
PHYDX
are
two strong options that fit the bill.
K
Contact Sumit Desai at
sumit.desai@morningstar.comHigh-Yield Rallies
Income Strategist
|
Sumit Desai