High yield bond market appears more attractive following selloff

July 2014 marked the first negative monthly return for high yield bonds since August 2013, as a cascade of negative press reports on high yield valuations sparked a selloff that led to heavy fund redemptions and downward pressure on prices. We believe that the selloff has been due to technical rather than fundamental (credit) factors, for a number of reasons.

  • First, the relatively narrow dispersion of returns between lower and higher-rated issues contrasts with previous bear-market inflection points, when the difference between high yield BB and speculative CCC returns ranged between 300 and 1,000 basis points. (As rated by a Nationally-recognized statistical rating organization.)
  • Second, the high yield default rate during the past 12 months fell in July to 1.95% from 2.06%, an absolute level and trend that is inconsistent with a deteriorating credit environment.
  • Third, small-cap high yield issues returned -0.7%, compared to large-cap issues, which lost 1.7%. In the team's view, this indicates selling pressure rather than credit-related repricing.
  • Finally, credit-related selloffs have historically been accompanied by heightened broad market volatility and weakness in equity markets. Neither has been present this time (with the exception of a recent selloff due to some geopolitical concerns).

Importantly for high yield investors, the recent selloff has added approximately 50 basis points in spread and 71 basis points in yield to the high yield bond market, with no change in fundamental credit quality. Further, U.S. economic data have, on margin, improved since early 2014, particularly on the all-important employment front.

Thus, the same high yield market of 30 days ago currently offers additional spread to absorb rate increases that we view as increasingly likely if economic trends hold and additional income in a yield-starved world. Barring a significant geopolitical event or U.S. economic setback, to us this argues for a near-term subsidence of outflows and a slow recompression of spreads. (Data: J.P. Morgan.)

The views expressed represent the Manager's assessment of the market environment as of August 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice.

A bear market is a general decline in the stock market (oftentimes greater than 20%) that lasts for an extended period, typically longer than two months.

Investing involves risk, including the possible loss of principal.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer's ability to make interest and principal payments on its debt.

Funds that invest in bonds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.

High yielding, noninvestment grade bonds (junk bonds) involve higher risk than investment grade bonds.

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Notes from the desk