The Up-in-Quality High Yield Dilemma
As we approach the end of the first quarter, it’s interesting to see how the U.S. High Yield (USHY) index has fared and what has driven its performance thus far. Rising interest rates have certainly been a key story for 2018, and their negative impact on fixed income affected the USHY index as well. One argument for investing in USHY has been its shorter duration and therefore it has less exposure to a rising interest rate environment, and we agree. With that said, not all bonds and bond ratings buckets react the same way to higher interest rates, so it’s worth taking a closer look.
The main detractor from USHY performance has been the highest quality bonds, those in the BB ratings bucket. As seen in the chart of the week, the USHY index has a negative return year to date, and BB bonds are the worst performing ratings bucket. The higher quality BB bonds are generally more rate sensitive and therefore don’t provide the same level of interest rate protection that the rest of the high yield index offers. However, most up-in-quality high yield managers prefer to own the highest rated (least credit risk) names, which can lead to underperformance relative to the USHY index in rising interest rate environments.
One way to remove some of the interest rate risk and still stay up-in-quality in high yield is to add some exposure to leveraged loans. Over the start of 2018, leveraged loans have performed very well, but CCC bonds have done even better. However, a high yield fund manager may get a similar level of outperformance in a rising rate environment by adding leveraged loans, and doesn’t necessarily have to sacrifice credit and rating quality by moving into CCC bonds.
With interest rates rising materially from the start of the year (the 5-year U.S. Treasury is up over 40 basis points (bps)), investors need to pick bonds that have the potential for spreads to compress enough to offset that size of a move. It’s difficult to do when the highest credit quality bonds in high yield started the year at a spread of about 230 bps. With the increase in rates and a widening of spreads to about 250 bps for BB bonds, it may be a better entry point for up-in-quality fund managers. With that said, leveraged loans may be a place to invest and maintain the credit quality of a portfolio, insulate it from higher rates and, as demonstrated in this week’s chart, potentially outperform USHY in the current rising rate environment.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.
High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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