Recent economic data and tea leaves from Fed officials have resulted in more challenging conditions for fixed income. Essentially, there is much less certainty about the timing and direction of the Fed’s next move as economic data and inflation have been more robust than expected. 

According to Michael Arone, chief investment strategist at State Street, this presents an opportunity with high-yield bonds given that yields are at attractive levels while a strong economy indicates that defaults will remain low. So far this year, high-yield bonds have outperformed with a slight positive return, while the iShares Core US Aggregate Bond ETF (AGG) and Vanguard Total Bond Market ETF (BND) are down YTD.

This is a contrarian trade as high-yield bond ETFs have had $387 million of outflows YTD, while fixed income ETFs have had $2.8 billion of net inflows YTD. It’s also a way for fixed income investors to bet that the US economy continues to defy skeptics and avoid a recession despite the Fed’s aggressive rate hikes. 

Currently, high-yield bonds have an average spread of 338 basis points vs Treasuries. Many of the most popular high-yield ETFs have effective durations between 3 and 4 years which means there is less rate risk. Spreads have remained relatively tight and could widen in the event of the economy slowing. 

Finsum: High-yield ETFs are offering an interesting opportunity given attractive yields. This segment of the fixed income market also is benefiting from recently strong economic data which indicates that default rates will remain low.