The US high yield market’s modest return in August obscured significant divergence of returns within the index. Portfolio Managers Seth Meyer and Brent Olson discuss why this dispersion demonstrates that opportunities exist in high yield, and why they believe active management is key to capitalising on those opportunities.
The Bloomberg-Barclays US High Yield Index was up 0.4% in total return terms for the month of August, and thus passively holding the index would have generated a small return. However, a closer look at the index constituents reveals that BB-rated credit – the highest-quality segment of the index – rose approximately 1.2%, while the lowest-quality segment (CCC-rated) experienced a dramatic drop of more than 2.2%.
Such large intra-index divergences tend to raise questions and, in our view, reveal potential opportunities. What explains a more than 3% difference in the total return of the BB and CCC segments of the high yield market?
Firstly, BB-rated bonds have historically been much more sensitive to changes in interest rates than CCC-rated bonds, regardless of their tenor. As global stocks wobbled and the US yield curve remained inverted during August, Treasury bonds generated strong performance. The benchmark 10-year bond rallied roughly 50 basis points (bps), providing robust support for BB-rated high yield bonds.
CCC-rated bonds, meanwhile, have historically been more sensitive to changes in the general economic outlook and the individual company backing the bond than they are to changes in interest rates, and thus their returns are often more highly correlated to stocks than to bonds. Indeed, energy-related companies make up a large portion of the CCC-rated sub-index and — as in the equity markets — these companies were particularly weak in August. In the US High Yield Index, energy sector spreads widened over 100 bps, more than twice that of any other sector, aside from autos and retail food and drug.
Looking at the high yield market overall, we maintain a neutral outlook, as we have for some time. Current yield spreads over Treasuries are tight relative to historical levels, but we think the levels are justified. Low yields in government bonds globally have created a shortage of yield, and the steady decline in high yield issuance adds to that scarcity. Furthermore, the percentage of CCC issuance continues to shrink, improving the average credit quality of the index.
As long as a slowing US economy remains a risk to bond markets, it is prudent, in our view, to favour relatively low volatility holdings that aim to provide reliable income. Within high yield, select companies and securities in the cable or healthcare sectors may fit that bill given the more stable profile of their cash flows compared to more cyclical sectors.
The recent dispersion in returns between BB and CCC-rated credits highlights the fact that opportunities exist in high yield. In our view, active management is a key component of capitalising on those opportunities while minimising the potential for swift, sudden or severe capital drawdowns.
Fixed income securities are subject to interest rate, inflation, credit and default risk. As interest rates rise, bond prices usually fall, and vice versa. High-yield bonds, or ‘junk’ bonds, involve a greater risk of default and price volatility. Foreign securities, including sovereign debt, are subject to currency fluctuations, political and economic uncertainty, increased volatility and lower liquidity, all of which are magnified in emerging markets.