Bonds: High Yield
Bonds are incredibly expensive right now, but despite this, they may keep going higher, says Goldman Sachs. The firm is specifically referring to high yield bonds, which are very pricey right now and have low spreads to Treasuries. For example, only 10% of high yield bonds currently trade with spreads above 5 percentage points above Treasuries, compared to 25% in November. This makes Goldman believe the easiest gains are already in the bag, but given that high yield bonds are sensitive to an improving economy and they have appreciated even while Treasuries have fallen, Goldman feels the asset class could be in for more appreciation.
FINSUM: This makes sense. It is also worth noting that historically speaking, high yield bonds have no correlation to the performance of Treasuries.
It is pretty easy to sum up what seems like it will be a forthcoming bull market in high yield bonds: “2021 will be the year of the upgrade”. That quote comes from Matt Brill, head of North America investment-grade at Invesco. Ratings agencies are reportedly on the cusp of upgrading between $100 bn and $300 bn of junk bonds to investment grade this year and next. Fund managers are trying to buy the bonds they think will be upgraded as such a move will cause a lot of arbitrary buying by index trackers.
FINSUM: There were huge downgrades last year as the pandemic wiped out prices in big parts of the sector. Now, with the economy resurgent, big upgrades look likely, which should give the whole asset class wings.
Until every recently (and even now), junk bond yields were historically low. This was not a surprise since Treasuries were also at historic lows. But the whole situation begs an important question—why are junk bonds so popular when their yields are so low? It seems like an abundance of risk with little return. The answer to the question is that “there is no alternative”. Many fund managers have mandates to invest in a minimum holding of bonds, no matter what their yields. Therefore, when that cash needs to find a home in fixed income, it naturally finds its way towards the highest-yielding bonds, even if those might be quite risky. This helps explains the huge decline in yields since March 2020 (from an average of 12% yield to under 4% in February).
FINSUM: “There is no alternative” (TINA), is the same explanation given for the big rise in equities since after the Financial Crisis, and even since the beginning of the pandemic. Frankly, the argument seems to hold water.
High yield bonds are in an interesting place. After yields fell very low during the core of the pandemic, the bonds looked relatively less attractive. Now, jumping Treasury yields have hit the asset class, but junk credit is relatively less affected because of its shorter maturities and higher yields. The reality though, is that even with things starting to look better given the recovery in the economy, it is a risky time. Therefore, junk debt is an area where active management might be the right choice. Individual credits can react very differently to market forces, and it takes a good deal of research to really understand the companies.
FINSUM: High yield managers are known for resisting the excesses of their asset class, something that index funds cannot do. Therefore, in risky times, it might be a good idea to stay active.
If investors’ eyes are watering from the big jump in yields over the last month, no one could blame them. The steep rise has sideswiped markets and until today, sent the Nasdaq into a full blown correction, with the rest of the market down strongly too. So how can investors protect their portfolios from losses because of yield jumps? One asset class to consider are rate hedged ETFs, such as the ProShares Investment Grade-Interest Rate Hedged ETF (Cboe: IGHG) and ProShares High Yield Interest Rate Hedged ETF (Cboe: HYHG). Both funds go long corporate bonds and short Treasuries, which allows them to remove rate risk, but still keep the benefit of income streams from the underlying corporate bonds.
FINSUM: Rates usually rise when the economy is improving, as is happening now. In these periods, corporate bond spreads usually tighten. So this type of ETF allows you the benefit from the increasing attractiveness of corporate bonds while also protecting against interest rate risk.
Treasury yields have risen significantly over the last few weeks. So much so that equities have been absolutely hammered. This has stoked a lot more interested in bonds generally because yields are rising back to more palatable levels. However, thus far, corporate bonds have been getting wounded during the Treasury yield surge. Top bond indexes, like the SPDR Bloomberg Barclays High Yield Bond ETF and the iShares iBoxx $ High Yield Corporate Bond ETF, have each seen major selloffs, with over 1% losses in a single day. Many analysts think that the rise in yields may curtail some corporate debt issuance.
FINSUM: So the immediate view for corporate debt is bearish, but in the medium term it is much brighter. As yields stabilize at higher levels there will be stronger investor demand, and coupled with less issuance, you will have a tight market.