High-Yield Corporate Bonds: Expect a More Sustainable Pace of Returns
Rising Treasury yields may weigh on high yield for the balance of the year, but positive returns should continue with additional spread compression and coupon clipping.
Since the market is no longer pricing in Fed tightening for the foreseeable future, a key investment theme this year has been extending duration. Based on net flows, high-yield mutual funds are capturing outflows from floating-rate bank loan funds and other sectors. This, coupled with a decline in rates, culminated in the high-yield corporate bond market’s best first-quarter performance on record. Spread compression was the biggest driver of positive performance, with total return of 7.4 percent and excess return of 6.3 percent over Treasurys.
High-Yield Index Posted the Best Q1 Total Returns on Record
Based on net flows, high-yield mutual funds are capturing outflows from floating-rate bank loan funds and other sectors. This, coupled with a decline in rates, culminated in the high-yield corporate bond market’s best first-quarter performance on record.
Source: Guggenheim Investments, ICE BofA Merrill Lynch. Data as of 3.31.2019.
Our Macroeconomic and Investment Research Group believes Treasurys are overbought and therefore expects a near-term bounce in yields. Higher rates would hinder returns but would mainly hurt BBs, whose average duration of 4.9 years is longer than the average durations of B-rated and CCC-rated bonds at 4.4 years and 4.0 years, respectively. Other factors that limit upside return potential include refinancing activity, which would decrease the coupon return (though this could be offset by new issue concessions), and default activity, which would lower loss-adjusted returns.
Our internal high-yield default model projects a slight pickup in default activity. As of the end of the first quarter 2019, the 12-month trailing par-weighted default rate stood at 0.6 percent, near historical lows, while our model projects it will pick up to about 3.0 percent by year-end. The par-weighted distress ratio, which historically has been a good predictor of directional changes in the default rate, was 6.5 percent as of the end of the first quarter. However, the distress ratio has overpredicted the default rate by an average of 10 percentage points historically. If the market expected a meaningful pickup in defaults, the distress ratio would be much higher.
Distress Ratio Historically Overpredicts Realized Default Activity
The par-weighted distress ratio, which historically has been a good predictor of directional changes in the default rate, was 6.5 percent as of the end of the first quarter. However, the distress ratio has overpredicted the default rate by an average of 10 percentage points historically.
Source: Guggenheim Investments, BofA Merrill Lynch Research, ICE Index Platform, Bloomberg. Data as of 5.31.2019.
Low defaults, spread compression, and coupons should more than offset the negative impact of higher benchmark rates in the near term. We see better relative value in middle-market bonds as the experience of the fourth quarter drove investors to bonds of companies with larger capital structures that are considered to be more liquid. Middle-market structures could reverse some of the widening from last year, and should perform better than large capital structures.
—Thomas Hauser, Senior Managing Director; Rich de Wet, Director
Important Notices and Disclosures
This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.
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