Corrections (declines of 10% or more) are a normal part of risk-market cycles, as we discuss in this quarter’s CIO Insights introduction. In the case of high-yield corporate bonds,¹ we believe portions of the market overcorrected in January and February this year in response to energy sector volatility, increasing default risk, and recession fears. Market extremes like this provide opportunities for active managers who use a fundamental approach for security selection.
Read MacEwen’s full Q2 2016 CIO Insight: Oversold Conditions Opened Select Opportunities in High-Yield
High-yield corporate credit, in tandem with the crude oil spot market, has experienced volatility since July 2014. Much of the volatility corresponded with the declining financial health of energy sector corporate bond issuers as oil prices collapsed. And some of that volatility has weighed on the values of high-yield bonds and sectors outside of energy. Other factors that contributed to the start of the high-yield market’s downturn in 2014 included the end of the U.S. Federal Reserve’s (the Fed’s) latest program of asset purchases, anticipation of Fed rate hikes as the U.S. economy continued to improve, and slowing global economic growth.
One of the most frequently used measurements of investor sentiment in the high-yield market is the difference in yields between high-yield and U.S. Treasury securities of the same maturity. This spread measures investor perceptions of the relative default risk between corporate and Treasury securities. Historically, this spread has averaged approximately 575 basis points (bps, 1 bp equals 0.01%), a significant yield difference that compensates investors for the greater default risk in high-yield. Spreads typically narrow when investors perceive corporate financial conditions are improving and widen when conditions are perceived to be deteriorating.
During the last five years, we’ve seen two distinct high-yield spread spikes associated with risk-off financial market trading. The first was in October 2011, during the European sovereign debt crisis, when spreads soared above 900 bps. The second was in February 2016, when spreads again approached 900 bps. These periods of spread widening were accompanied by corresponding bond price corrections. In the most recent occurrence, we believe too much worst-case scenario sentiment was priced into the high-yield market, given our analytical view that China will avoid an economic “hard landing” and the U.S. will avoid recession. Based on their fundamentals, we believe select high-yield securities outside the energy and materials sectors were priced attractively at these generally wider spread levels. Part of our fixed-income investment philosophy is that markets tend to revert to historical normal levels from extreme positions, such as the one reached in February.
Our “select opportunities in high-yield” stance is represented in the bond portfolios we manage. In our core diversified taxable bond portfolios, we have a small overweight position in BB, short-maturity high-yield bonds. In our portfolios geared for investors with higher risk tolerances, we have recently increased our high-yield targets. In these portfolios, the high-yield exposure is based on bottom-up security selection and is highly diversified across many industries.
In conclusion, active managers in fixed income, like us, view periods of extreme credit spread widening with a practical eye—we don’t expect spreads to remain at such extremes. Opportunities exist to find fundamentally sound high-yield credit issuers that can benefit from spread narrowing. That’s part of the added value that active fixed-income managers can provide.
1 A higher-risk, high-yielding taxable bond sector comprised of debt instruments from corporations rated below BBB- by Standard & Poor’s.
Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.
The opinions expressed are those of G. David MacEwen and are no guarantee of the future performance of any American Century Investments portfolio.
For educational use only. This information is not intended to serve as investment advice.