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Why You Should Avoid High-Yield Bonds In The Energy Sector

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In my opinion, investors have been stretching too far for income for yield and ignoring risk. While there are few bargains within fixed income, I continue to like those parts of the market that offer some relative value, including tax-exempt bonds and mortgage-backed securities. In addition, for more yield hungry investors, I’d advocate some exposure to U.S. high yield, but with a caveat. You can read more about my fixed income outlooks in my latest Investment Directions monthly market commentary.

Avoid high yield bonds in the energy sector for now

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Market Realist – For now, you should avoid high-yield bonds in the energy sector.

The graph above compares yields on the ten-year Treasuries (IEF) and high-yield corporate bonds (HYG)(JNK). The spread between the two decreased since the peak of the financial crisis.

The yield for ten-year Treasuries is 2.1%. High-yield bonds are returning close to 7.5%. This means the spread is ~540 basis points—compared to slightly above 1,800 basis points during the crisis. Treasuries are considered to be very safe because they’re backed by the US government. That’s why they command a premium. It’s also why they trade at lower yields.

High-yield bonds usually do well when the economy is doing well. This is because credit markets improve and their cash flows are higher. As a result, the probability of high-yield bonds defaulting is less. The opposite happens when the economy is in a recession.

However, the current scenario demands some caution before buying high-yield bonds. Due to the sudden slump in crude oil (USO) prices, energy companies’ (XLE) cash flows are at risk. As a result, you should avoid high-yield bonds in the energy sector.

Read Market Realist’s The New Fixed Income World for more information on the fixed income sector.

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