When building an efficient portfolio, most market practitioners would agree to an allocation to bonds. This allocation reduces the overall volatility of the portfolio and adds a layer of safety. The two main components affecting fixed income returns are: 1). interest rates and 2). the credit quality of issuers. With the recent increase of interest rates and the Fed’s plan to incrementally increase rates over the next few years, we feel investments in credit, especially high yield, offers better return potential to investors.
High yield bonds tend to deliver the potential to improve a portfolio’s overall risk/return given the historically low correlation with other core asset classes. Due to their location on the credit spectrum, high yield bonds offer enhanced yields compared to high quality bonds and can potentially increase the overall yield of a portfolio significantly. Although this has not been the case as of late, historically speaking, high yield bonds have provided better downside protection than equities while delivering equity like returns with significantly less volatility and drawdowns.
When assessing the outlook for high yield bonds, we want to be cognizant of the underlying: fundamentals, technicals and valuations.
Credit markets have historically done well during economic expansions and have performed poorly during recessions. As stated in our 2016 Outlook, we see economic growth continuing around 2.3% in 2016. This growth rate plays well for high yield as it is not high enough to encourage unsuitable debt loads for issuers, but not so low to increase default rates. Domestic balance sheets still remain strong and companies have excess cash to help support current debt payments.
A significant amount of the drawdown experienced as of late can be attributed to large swings into and mostly out of actively managed fixed income funds. These significant fast money swings has led to what we feel are strong buying signals at attractive valuations.
High yield bonds are currently priced close to or below par value. These current valuations present opportunities for price appreciation on the underlying security on top of a high current coupon payment. Current spreads on high yield are well above their historical average and present a great entry point for fixed income investors.
The Investment team at Janiczek is monitoring the always changing investment markets and are poised to make the necessary changes to our portfolios. We currently favor credit risk over interest rate risk for the above reasons. We are currently allocated to take advantage of the high yield space and feel there is tremendous opportunity here in 2016. Please refer to Evidence Based Investing for a more detailed look at our investment process.