By JULIANNE BASS, CFA, Senior Portfolio Manager of Fixed Income Investments
The same catalysts driving the U.S. stock market — global economic growth, improving earnings and the prospects of pro-corporate changes in the tax code, all against a backdrop of very low interest rates — are also supporting the high-yield bond market.
We keep hearing warnings about high-yield because of how tight credit spreads are. It’s true that spreads for high-yield credits are at their narrowest against Treasuries in about three years, as the global demand for yield has bid up their prices. Implicit in the warnings is that spreads this tight are a harbinger of widening spreads around the corner.
We’re not so sure about this scenario. First of all, while high-yield spreads are tight, they are still roughly half a percentage point wider than their post-financial crisis low. And tight spreads don’t necessarily beget wider spreads — both investment-grade and high-yield corporate bonds traded at their current spreads for several consecutive years in the 1990s, when the U.S. economy was doing well.
That raises the question of what would be the trigger for widening credit spreads, which reflect investors requiring more yield as compensation for owning bonds they perceive as riskier. Spreads for high-yield as an asset class would likely widen if the market believed the economy was slowing and that issuers might have difficulties servicing their debt, but the U.S. economy appears to be growing, however modestly. At a bit over 1%, the current default rate for high yield is extremely low.
High-yield is maintaining its long-term trading pattern — its total returns are falling between equities and higher-rated bonds. A deviation from that pattern can be a signal that one or the other of these asset classes — stocks or high-yield bonds — is heading for a correction.
And with regard to interest rates, high yield has tended to be an attractive asset class in rising-rate environments because their higher coupons provide more of a cushion against the negative effects that rising rates have on bond prices. In the years after the financial crisis, high yield has performed well during those periods when Treasury yields have risen.
All of this said, some high-yield sectors are experiencing widening spreads due to their specific market challenges.
Bonds issued by traditional retailers, for instance, are struggling in the face of disruption from online sellers with cheaper overhead. In health care, some drug makers are dealing with large debt burdens and hospital chains with Affordable Care Act-related uncertainties that could potentially diminish their cash flows. Current oil prices are pressuring many energy firms that loaded up on debt when crude’s price was over $100 a barrel.
But even within troubled sectors, opportunities can be found. One area of interest to us now is oil-field services: companies that do geological testing, drilling, oil-well construction and maintenance, and other important tasks.
Demand is picking up for service providers as the rising price of oil has led producers to increase their exploration budgets and finish wells that had been on hold. And while contracts with the producers are not as lucrative as they once were, the oil-field service companies have slashed their cost structure and become more efficient operators. The companies we like have strong liquidity positions and deep backlogs of work.
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The fixed income securities are subject to price volatility and a number of risks, including interest rate risk. Interest rates and bond prices move in opposite directions so that as interest rates rise, bond prices usually fall and vice versa. Interest rates are currently at historically low levels. Fixed income securities also carry other risks, such as inflation risk, liquidity risk, call risk, and credit and default risks. Lower-quality fixed income securities involve greater risk of default or price changes. Securities of non-U.S. issuers generally involve greater risks than U.S. investments and can decline significantly in response to adverse issuer, political, regulatory, market and economic risks. Fixed income securities sold or redeemed prior to maturity may be subject to loss.
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