Junk bonds can be a good play for returns competitive with stocks but less volatile

By Philippe van Doorn

High yield bonds have held up better than investment grade bonds and the S&P 500 this year

This is the third article in a three-part series on bond market opportunities. Part 1 covers the shorter end of the yield curve. Part 2 is a guide to investing in tax-exempt municipal bonds.

Some professional bond market investors expect interest rates to peak soon. If they are correct, the time has come to accumulate bonds.

Kevin Loome, lead portfolio manager of T. Rowe Price’s US high-yield bond strategy, explained why junk bonds have held up better than investment-grade corporate bonds this year. He also described the opportunities and risks of this asset class through an economic cycle.

When interest rates rise, bond prices fall. This may be considered bad news, but it also makes bonds more attractive to investors who are making new purchases because their yields have risen.

The environment for investors looking for income is therefore much better than it was at the end of 2021. But for investors looking for capital gains, it may also be a good time to buy stocks. discounted bonds. When interest rates eventually drop, bond prices will rise. In the meantime, the higher yields will make the wait easier.

For high yield bonds – those rated below investment grade, also known as junk bonds – the opportunity may be even greater than for more conservative bond choices, as higher risk may mean greater reward through higher price appreciation. Investment grade bonds are those rated BBB- or better by Standard & Poor’s and Fitch, and Baa3 or better by Moody’s. Fidelity breaks down the hierarchy of credit agency ratings.

The ratings reflect the agencies’ views on the risk of default by bond issuers – non-payment of interest or principal. The risk of default is higher for high yield bonds, which is why they trade more on fundamental financial health than interest rates, and can provide returns “competitive with equities, with much volatility.” weaker,” according to Loome.

High yield bonds held up relatively well

Year-to-date, the ICE BofA US Constrained High Yield Bond Index is down 17%, although its total return with dividends reinvested was 12.2%. This bond index is “constrained” because the bonds of no issuer can represent more than 2% of the main value of the index.

Now check out this chart comparing the year-to-date returns of the ICE BofA US Constrained High Yield Bond Index, the ICE BofA Corporate Index (which holds investment grade rated bonds) and the S&P 500 to 1st november :

During an interview, Loome said that high-yield bonds are performing better than investment-grade bonds and the broader stock market due to their higher interest payments.

And it illustrates how much more attractive this space has become: the weighted yield to maturity of the ICE BofA US Constrained High Yield Bond Index rose to 9.10% from 4.92% at the end of 2021, while the worst-case yield, which in the call dates when issuers can redeem bonds for the first time, rose from 4.33% to 9.07%.

The credit cycle

If a bond is trading in the open market at face value, we say it is trading at par, or 100. If it is trading below 100, it is at a discount. If it’s over 100, it’s a bonus.

Loome said the average bond for the ICE BofA US Constrained High Yield Bond Index was trading at 85.5 cents on the dollar as of September 30, down from $103.25 at the end of 2021.

Thus, the average junk bond in the index is trading at a 14.5% discount to face value, which will ultimately be repaid unless the issuer defaults.

Loome said it’s impossible to predict default rates because they can vary widely depending on the nature, duration and depth of an economic crisis. But he cited a Bank of America statistic that, over the long term, the index’s average default rate was just under 4%. He also said recovery rates for high-yield bonds have historically averaged around 40% after defaults, which may help maintain a floor for junk bond prices.

“This year the default rate is going to be really low,” he said, reflecting the growing economy and slowing issuance of new high-yield bonds.

During the Covid-19 pandemic and its aftermath, high-yield bond issuers took advantage of low interest rates to lock in funding, Loome said, adding that “maturities overall aren’t really warming up. before 2025”.

It all depends on what you, as an investor, expect. Do you see the Federal Reserve shortening its cycle of interest rate hikes soon? Do you think there will be a soft landing or, at worst, a relatively mild recession? Both of these scenarios would favor a recovery in bond prices.

The Federal Open Market Committee provided an update on the economy on Wednesday after raising its target range for the federal funds rate another 75 basis points to 3.75% from 4.00%. Federal Reserve Chairman Jerome Powell said the window is narrower for a soft landing, even as the economy grew 2.6% in the third quarter. He also said interest rates would likely end up being “higher than expected.”

Bond funds and ETFs

Loome manages the T. Rowe Price US High Yield Fund, which has approximately $422 million in assets under management and a 30-day dividend yield of 7.79% as of September 30. The fund’s weighted average duration was 4.3 years as of September 30. Duration is a measure of volatility, explained in detail here.

The T. Rowe Price US High Yield Fund was originally the Henderson High Yield Opportunities Fund, which T. Rowe Price acquired in 2017. Loome has managed the fund since the inception of the predecessor fund on April 30, 2013. From that date to As of September 30, 2022, the fund’s average annualized retail equity total return was 3.65%, higher than the average return of 3.24% for the ICE BofA US Constrained High Yield Bond Index.

For Class I shares of the T. Rowe Price US High Yield Fund, the average annualized return from inception through September 30 was 3.84%. Class I stocks have an annual expense of 0.61% of average assets under management, while the expense ratio for retail stocks (TUHYX) is 0.75%.

Loome also manages the T. Rowe Price US High Yield ETF (THYF), which was launched on October 26 and is managed with the same strategy as the mutual fund. It manages a total of $2.3 billion under a high-yield strategy, including cash in segregated client accounts.

He said actively managed exchange-traded funds are not common in the high-yield space.

The two largest competing passively managed ETFs are the $14.2 billion iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the $8.6 billion SPDR Bloomberg High Yield Bond ETF (JNK). HYG’s 30-day yield was 8.13% and its weighted average duration was 4.2 years as of September 30. JNK’s 30-day yield was 8.78% and its weighted average duration was 4.2 years.

Over long periods of time, it is difficult for an actively managed high yield bond fund to outperform the index because of expense, but also because an index has no difficulty adding newly issued bonds, whereas a fund manager may compete to buy them when supply is low. limited, Loome said. He added that active managers tend to outperform passively managed funds over long periods.

He said actively managed funds had advantages, including lower transaction costs, as investors were less likely to jump in and out quickly than they were with passive funds.

So far this year, the T. Rowe US ​​Price High Yield Fund has underperformed the ICE BofA US Constrained High Yield Bond Index and the two ETFs:

Loome explained that this year’s underperformance stemmed from its decision to load into CCC-rated bonds at the end of 2021, aiming for higher yields.

“Usually what happens is that when the market recovers, people focus on the safe side, BB and B. But at the end of the recovery, they enter the CCCs. We have to be patient to let it happen, but we believe it will happen in 2023,” he said.

Don’t miss: 20 dividend-paying stocks that could be the safest if the Federal Reserve causes a recession

-Philip van Doorn

 

(END) Dow Jones Newswire

11-05-22 0926ET

Copyright (c) 2022 Dow Jones & Company, Inc.

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