For investors, the implications are not to load up on bonds, but to tactically look for areas of relative value within fixed income.
The asset class is starting to stabilize after a torrent of supply put it under pressure for most of the spring. Long-dated municipals currently offer the potential opportunity for an incremental pickup in yield relative to Treasuries.
High Yield Bonds
Despite recent underperformance, they still offer a reasonable yield, and with the economy improving, there is less risk of a material rise in defaults.
Market Realist – Areas of relative value within fixed income.
The above graph shows the spread between the Merrill Lynch High Yield Master II effective yield and the yield on the ten-year Treasury (IEF).
High yield bonds (JNK) (HYG) entail credit risk or the risk of defaulting, while U.S. Treasuries don’t. The difference in the yields of the two, or the spread, indicates the level of risk the market perceives high yield bonds to have.
Usually, when credit markets are deteriorating, the spread increases. Investors flee from high yield bonds and move toward safety, leading to a dip in Treasury yields. This is because a deteriorating economy increases the chances of junk bonds defaulting. The opposite happens when the economy is improving.
High yield issuers in the energy sector currently make up ~15% of total high-yield bond issuers. The spread expanded to ~500 points in February 2015 as fears of default gripped investors. However, the spread has currently contracted back to ~400 basis points due to higher oil prices.
The credit market seems to be in shape. High yield offers yield-thirsty investors an avenue for higher yield in a world of ultra-low yield.
The graph above compares the year-to-date returns on four bond ETFs. Except for high yield bonds (HYG), all other ETFs have given negative returns. The iShares Barclays Aggregate Bond Fund (AGG) has dropped by 0.8%, while the iShares Barclays 20+ Year Treasury Bond ETF (TLT) has dipped by 6.4%. TLT tracks the performance of the highly sensitive long-dated Treasuries. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) has eroded investor wealth by 2.0% year-to-date. Typically, high yield bonds outperform when interest rates are rising.