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Why bond investors should favor high yield over investment grade

Credit risk has been a key return factor for corporate bonds

This week’s economic data releases have a shared theme: continued slow and steady economic recovery. As business conditions improve, the risk of default falls for companies that issue debt. Since high yield companies (HYG) are riskier than investment-grade companies (LQD), economic improvement helps them more than it does the stalwarts.

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Rising interest rates also pose a more significant threat to investment-grade bonds than high yield bonds. This is because improving economic conditions drive rates higher, but systematic changes in spreads (the difference between bond yields and Treasury yields) tend to move on a relative basis. This means that if the yield curve widens by 50 basis points and spreads tighten by 10%, you could have a situation where high yield bonds have positive price performance and investment-grade bonds have negative price performance due to the differences in spread.

Rate exposure will be important going into 2014

Investment-grade corporate bonds had a 72% correlation to Treasury returns (IEF) over the last three years, while high yield corporate bonds actually had a negative 30% correlation over the same period. The biggest macro event in 2014 will probably be when the Fed tapers asset purchases. Depending on how the Fed manages the market’s expectations for future monetary policy, the taper could lead to rates rising a little bit or a lot. For rates to fall, the economy would have to slow considerably from here, which seems unlikely given the current trend in macro data and the scrutiny over the Fed’s forward guidance.

Of course, anything said about high yield goes double for stocks, and investors with higher risk tolerances should definitely favor stocks over bonds in this environment.

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