Hedging downside risks after high yield's big run

Risk assets of all varieties have benefited from the post-November “Trump bump,” and high-yield bonds have been no exception.

In fact, the asset class posted fairly steady gains throughout 2016, and as of the end of January, high-yield bonds had recorded their best rolling 12-month excess return in nearly seven years versus the Bloomberg Barclays Aggregate Bond Index.1 It's no surprise, then, that flows into the asset class have been just as strong: In December alone, high yield took in roughly $8 billion in net assets, outpacing all but two Morningstar categories.2

Is the recent rally in high yield bonds nearing an end?

The question we've been asking our network of asset managers and investment partners is whether this recent run of strong performance can continue, and how investors can best hedge the downside risks. The consensus among the fixed-income managers we spoke with was that the U.S. economy should do relatively well over the next year. The U.S. leading economic indicators for December ticked higher on a year-over-year basis with relatively positive readings from the manufacturing sector, consumer confidence, and supportive credit conditions. And with the new Trump administration looking to implement a number of pro-growth reforms—tax cuts, increased fiscal spending, and deregulation chief among them—the outlook for high-yield debt remains promising.

That said, the outsized excess returns in high-yield bonds over the past year suggest that optimistic investors may have priced in more of an economic uptick than policy changes are able to provide; high yield could be in for a bumpy ride if stronger economic growth is slow to materialize. The political strategists that we look to in building our own analysis point out that most new administrations need an adjustment period as they work to better streamline formulating policy. This could result in a longer timetable for implementing some of these economic policies than investors originally forecast.

With that in mind, investors may want to consider balancing their high-yield exposure with higher-quality corporate bonds. On a bottom-up basis, our managers find investment-grade corporates offer a number of benefits, including low correlation to equity markets and a relatively attractive yield of 3.4%.3 Plus, by using an active approach, investors can target specific maturities that may offer a lower sensitivity to interest rates than the broad market index.

While we still believe high-yield bonds have merit in portfolios, the wave of recent inflows and strong relative returns may be a signal that investors should look to balance their exposure with allocations that have greater focus on risk mitigation and downside protection; investment-grade corporates could be worth a closer look.

 

1 FactSet, as of 1/31/17.

2 Morningstar Direct, as of 1/31/17.

3 Bloomberg, as of 1/31/17.