High yield bond sell-off: A must-know investor outlook

By

Updated

So what does this mean for investors? We have been neutral on high yield (HYG) for the past few months as it has offered more income potential than other asset classes. High yield remains a potential source of income in a diversified portfolio, but potential price appreciation is limited.

High correlation between CDS rates and OAS

Market Realist – The graph above shows the correlation between CDS spreads and high yield option-adjusted spreads (or OAS).

Article continues below advertisement

The S&P/ISDA CDS U.S. High-Yield Index has been taken to indicate CDS spreads. It shows the average spreads required to buy protection against 80 equally weighted U.S. entities (according to S&P Dow Jones Indices). A higher index level means that purchasing default protection has become more expensive.

High yield (JNK) option-adjusted spreads and CDS spreads generally move hand in hand since a wide divergence can open up the possibility of arbitrage, which the market will quickly take advantage of and eliminate.

Both CDS spreads and OAS drastically increased at the end of July. The high correlation in the recent drawdown may point to a solid move rather than a one-time drawdown. You could attribute this high correlation to a decreasing appetite for credit risk by investors who are now turning to investment grade bonds (LQD)(AGG) and Treasuries (TLT)(IEF). This trend could continue, so there’s likely to be limited possible price appreciation in high yield bonds.

Article continues below advertisement

The recent sell-off is also a good reminder to investors of the potential volatility of the asset class. Given current yields, investors have to weigh whether they are being paid enough to take on this volatility and the underlying credit risk. Another consideration is whether recent price movements represent a temporary setback for the high yield market or the beginning of a broader re-pricing of corporate bonds. Given overall economic conditions I doubt that there will be any contagion into investment grade debt. For now, I continue to be neutral on high yield.

Market Realist – Read our series Why investors should watch for asset class deception to understand the risk of investing in high yield bonds.

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting the iShares ETF and BlackRock Mutual Fund prospectus pages. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Article continues below advertisement

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.

The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by Markit Indices Limited, nor does this company make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with Market Indices Limited.

Advertisement

More From Market Realist