High-yield bonds have had a fantastic run in 2016 (total return 18%) and spreads have continued to tighten since the beginning of 2017. We keep seeing article after article questioning the prudence of staying in high yield given the large compression in high-yield spreads coupled with rising interest rate environment. We do not see these issues as headwinds and in fact believe that high yield is likely to perform reasonably well in both a rising interest rate environment as long as the economy continues to grow at its current pace and defaults are not expected to increase beyond historical measures.
High yield bonds have worked during previous rising rate environments. Since 1987, there have been 16 quarters where yields on the 5-year Treasury note rose by 70 basis points or more. During 11 of those quarters, high yield bonds demonstrated positive returns; during the five quarters where high yield bond returns were not positive, the asset class rebounded the following quarter. In fact, in the 37 years since 1980, the high yield bond asset class only experienced negative returns in five calendar years.
In my piece, Getting Defensive in High Yield, I discussed how one who is concerned about high yield can reduce risk by shortening duration and improving credit quality. I also discuss the factors that are likely to have impacts on spreads in 2017.
A bond with a five-year duration will lose roughly 5% for a 1% rise in rates (or a 100bp widening in spread). This capital loss will be offset from the bond's coupon. We can see this is quite a favorable breakeven ratio. In fact in the past few months we have seen the yield on the five-year Treasury note increase about 50bps which was fully offset by both coupons and high-yield spread compression.
If we look at the performance of high yield versus the S&P 500 over the past 10 years, it's quite amazing to see that high yield has both outperformed stocks and with much lower volatility.
There are a myriad of ways to play high yield both as a passive investment (HYG or JNK) or through a plethora of high-yield closed-end funds and ETFs. Its important to realize that high yield has had a great run, and while the likelihood of additional spread tightening is low, this does not preclude the asset class from sustaining current spreads for the intermediate term as default rates should remain low and economic activity should remain positive.
Those concerned with the risks in high yield can raise a little cash and/or reduce duration and improve credit quality. However wholesale recommendations to abandon the class due to the perceived asymmetric risk/reward profile can find themselves waiting an awfully long time and losing a significant amount of coupons waiting for the "correction". In fact we had this correction in the beginning of 2016 and it was short lived. Don't hold your breath waiting for the next one. Regardless of how you decide to play, the outlook for high yield looks solid.
Disclosure: I am/we are long HYG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.