High Yield Bond Outlook For 2017 – Time Just To Earn The Yield
Jan. 5, 2017 7:30 AM • hyg
- High yield bonds have had a volatile two years, down 5% in 2015 and up 17% in 2016.
- Over the two years, the returns smooth out to an annualized 6% – basically at the yield of the asset class.
- Assuming no major market shocks in 2017, high yield is simply poised to earn its yield in 2017.
The high yield market has been a roller coaster over the past two years with about a 4.6% decline in 2015, followed by a 17.4% jump in 2016 based on the BofA Merrill Lynch US High Yield Total Return Index. Looking at iShares iBoxx High Yield Corporate Bond ETF (NYSEARCA:HYG ), there was a 5.6% decline in 2015 and a 13.9% rise in the index. Much of the volatility in high yield is due to the energy and commodity crash that began in late-2014, with recovery in spring 2016.
While the double-digit gain in 2016 may seem to indicate inflated values for high yield bonds, looking at the two-year period shows no “bubble” in high yield. In fact, high yield’s annualized returns over 2015 and 2016 only come to 5.9% – which not surprisingly is in the range of the effective yield for high yield today, about 6.1%. Looking at HYG (see chart below), we can see that the current market price for the ETF is still 3.0-3.5% below early 2015 levels, which means bond prices on average remain below those of two years ago – again, not evidence of a bubble. Bond prices in 2016 merely recovered from steep declines in 2015; many bond declines were not warranted, as a large percentage of these issuers were nowhere close to bankruptcy (e.g. many midstream MLPs) and the market adjusted back in 2016. Over time, the fluctuations in the market values of bonds smooth out, and the returns approximate the actual yields offered by the bonds.
What are my expectations for high yield in 2017? This year, the goal is to simply earn the yield on high yield bonds, which is in the low 6% range for the index (current yield for HYG is in the mid-5% range, which includes the ETF fee of 0.50%). Ideally, the aggregate market value of a given high yield bond portfolio at year-end 2017 will be similar to that at the beginning of the year, leaving only the interest income earned as the total return for the year. Barring any major market shocks (like a significant stock market decline), this seems to be a likely outcome for high yield.
With seeming stability in the energy market, bond prices should be less volatile this year. If energy does crash again, the high yield market is likely to be far more resilient for several reasons: (1) many of the weak energy players have already filed for bankruptcy, names like Linn Energy (LINEQ), Energy XXI (EXXIQ) and Swift Energy (SFY). Others weak players remain at distressed levels and investors have already taken the “hit” on these names. The weak bonds have mostly been swept away, and the remaining players are much better positioned to withstand an energy crash; (2) the market realizes that the midstream MLPs performed just fine in the past two years, and these bonds, which have recovered dramatically, will likely be far more stable in a future energy crash; (3) Other sectors have also been “cleaned out” of the high yield market in the past two years, names like Peabody Energy and Arch Coal.
What about rising interest rates? After all the 10-year Treasury bond yield increased from about 1.8% at the time of the election to the 2.4-2.5% range today, a sharp rise. As noted in a previous article. since 1987, there have been 16 quarters when the five-year treasury note yield rose by 0.70% or more – during 11 of those quarters high yield bonds had positive returns, and in the other five quarters, high yield bonds fully rebounded in the subsequent quarter. So how did high yield perform in November and December 2016 when rates were on the rise? They generated a 1.6% total return, once again defying the incorrect notion that rising rates are automatically bad for high yield bonds. If rates continue to rise this may lead to some short-term declines in high yield bond prices, but we expect the impact to be absorbed, offset by the earned interest. When rates rise it usually means a strong economy, which tends to buoy high yield bonds.
What about liquidity issues? We continue to read about possible liquidity problems in the high yield bond market, although this has yet to be proven. (Some might point to the Third Avenue Focused Credit Fund event in December 2015, but this fund was not a high yield bond fund, but really a distressed fund, with half its holdings in unrated bonds, and other bonds mostly CCC rated). In fact, a relatively recent report by the chief economist of FINRA (Analysis of Corporate Bond Liquidity, December 2015), an unbiased observer, concluded based on analysis of corporate bonds transactions from 2003 to 2015 (both investment grade and high yield) that:
“Most measures suggest a healthy market: Across both segments [most active issues and less actively traded bonds], transaction volumes have continued to grow, the number of trades is rising, bid-ask spreads have narrowed and the impact of trades on price continues to fall.”
The reports added that the “market has a larger number of issues, more electronic trading, and growing network of counterparties.” The fact is that while bank inventories of bonds are lower, other measures of liquidity, such as market size and trading volumes, are improved. Electronic trading and its impact on liquidity is likely a key factor that is difficult to quantify.
In a market crisis, it is still very likely high yield bonds prices will fall, but this is usually the case in a sharp market decline. However, the experience of the last two crashes indicates that the decline in high yield will be far less than that of stocks, and the recovery in high yield occurring much faster.
I continue to recommend holding individual bonds as opposed to an index fund, since individual bonds allow the investor to buy-and-hold-to-maturity and thus ignore price volatility or liquidity concerns, and also allow an investor to avoid obviously weaker credits which an index by definition includes. An index fund also will expose investors to the full brunt of possible liquidity issues, as price declines will lead to selling of the index ETF, which will lead to the ETF to selling the underlying bond holdings to meet fund redemptions – which means the fund is selling bonds at the worst time instead of buying and holding. On the other hand, over time, the ETF will likely perform just fine; after all the high yield indexes have outperformed the S P 500 by about 2.5% points per annum for the past 17 years (since 1/1/2000).
While it is impossible to predict where the high yield market will be this year, my expectation is that this may be the year where the asset class merely returns its yield, with returns somewhere in the 6% range. High yield bonds appear to be in the fully-valued to slightly overvalued range right now, so investing in high yield as a “trading play” or in hopes of rising bonds prices is not recommended. Last January it was clear that high yield was grossly undervalued, and I stated that “opportunities abound” in the market in this article. I was particularly bullish on midstream MLP bonds, an indeed, experienced 20-30% returns for many of these bonds issues in 2016. My specific recommendations in that article also all performed very well; Leucadia (NYSE:LUK ) bonds up 17%, Century Communities (OTC:CEMMZ ) up 19%, Suburban Propane Partners (NYSE:SPH ) up 12%, Prospect Capital (NASDAQ:PSEC ), an investment grade name, up 10.7%, and two Radian Group bonds up 12.6% and 22%. I do not see these type of “screaming buys” today that can generate these kinds of returns. Right now I prefer to lock in 6-7% yields in individual bonds with decent credit profiles, with six year and less maturities.
I will be writing more about high yield bonds in the coming weeks and months and expand on all the topics discussed above.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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