Forecasting U.S. High-Yield Bond Returns

|
Includes: FLOT, HYG
by: Data Focus

Summary

The U.S. high-yield bond index is up 1.8% year to date.

High-yield bonds are still expensive.

The base case of the high-yield bond total return is 0.9% for the rest of 2018.

Editor's note: Seeking Alpha is proud to welcome Data Focus as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to the SA PRO archive. Click here to find out more »

The U.S. high-yield bond index is up 1.8% year to date as of Oct. 9. In this article, we will forecast its potential return for the rest of 2018.

Background

The U.S. high-yield bond market was developed in the 1970s. The best time to invest in high-yield bonds is during the expansion stage of a business cycle, such as the one in 2009 (up 57.5%). The worst time to invest is at the beginning of a recession, such as the one in 2008 (down 26.4%).

Figure 1

Table 1

Year

High-Yield Bond Index Total Return

2008

-26.4%

2009

57.5%

2010

15.2%

2011

4.4%

2012

15.6%

2013

7.4%

2014

2.5%

2015

-4.6%

2016

17.5%

2017

7.5%

Source: FRED - BofA Merrill Lynch U.S. High-Yield Master II Total Return Index Return

During the current expansion stage since June 2009, there were periods when high-yield bonds experienced a decline. One example is when commodity prices - especially crude oil prices - collapsed in 2015.

High-yield bonds are still expensive, even though the index price is down 0.73% month to date due to the bond market sell-off. The option-adjusted spread (OAS) above the treasury curve reflects the risk level of high-yield bonds. On Oct. 3, when the bond market sell-off had just began, it decreased to 3.16% - the lowest level since 2008 (see Figure 2). The OAS has been widening since then, and reached 3.41% on Oct. 9 - still at a historical low since 2008.

Figure 2

For high-yield bond portfolio managers who try to beat the benchmark, it remains risky to sit on the sidelines - even in the face of high valuation, further interest rate hikes, and potentially higher default risk. Timing the market is always difficult. If a certain amount of cash is set aside for being conservative, it might be difficult to just watch when the market stays relatively calm and high-yield bonds keep generating high coupon income.

Forecast

High-yield bonds pay higher interests than investment grade bonds because of the higher risk of default. For example, the high-yield bond effective yield was 6.48% on Oct. 9, compared with the investment grade bond effective yield at 4.24%. In general, 6.48% is the return investors expect from the high-yield bond investment in a year. Note that at the beginning of 2018, its effective yield was 5.84%. While this was the return that investors expected for all of 2018 a little more than nine months ago, the actual year-to-date return is only 1.8%.

What will high-yield bonds return for the rest of 2018? A bond's total return comes from price return and coupon return. If the treasury yield curve and the OAS don't change at the end of the year, assuming the duration of the high-yield bond index stays the same, the return for the next 12 weeks would come from coupons: 6.48%*12/52=1.5%. Considering the probability of the Fed funds rate being raised by 25 basis points in December is about 80%, our base case is that the treasury yield will increase by 25 basis points from the level on Sept. 26 when the Fed raised the rate, and the OAS stays at the most recent level.

This will lead to a negative price return: -(0.25%-0.09%)*4=-0.6%, where 0.25% is the expected yield increase from Sept. 26 to the end of 2018, 0.09% is the four-year treasury yield increase from Sept. 26 to Oct. 9, and four (years) is the high-yield effective duration. The total high-yield bond return for the rest of 2018 will be about 0.9%, and the total return for the entire 2018 is expected to be around 2.7%.

In an upside scenario, if the high-yield bond price doesn't drop, the total return for the rest of 2018 would be 1.5%. In a downside scenario, if the economy slows down in a nondramatic way the OAS could increase by 1%, there wouldn't be a rate hike, and the yield curve wouldn't change. This would cause the price to drop 4% and lead to a total return for the rest of 2018 at about -2.5%.

Conclusion

The base case of the U.S. high-yield bond total return is 0.9% for the rest of 2018 and 2.7% for all of 2018. Is it a good idea to invest in high-yield bonds now? In the event of a market sell-off, the liquidity risk of high-yield bonds is very high. Meanwhile, we note that investment-grade floating rate bonds can have similar expected returns, less liquidity risk, and less volatility. Furthermore, floating rate bonds will be less impacted by a rate hike due to a shorter duration. Investing in investment-grade floating rate bonds would be a better alternative to investing in high-yield bonds for the rest of 2018.

Disclosure: I am/we are long FLOT.

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.