High yield maintains its edge
Despite a generally lackluster environment for fixed income, the high-yield market continues to perform relatively well. For example, as of June 30, the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index was positive on a monthly, quarterly and year-to-date basis. By contrast, its high-quality counterpart, the Bloomberg Barclays U.S. Aggregate Bond Index, was negative for all three periods.
In fact, high yield has outperformed high quality for 10 consecutive quarters. To be sure, the ride has been far from smooth, especially given the challenges of rising yields and volatile credit spreads—that is, the gap between yields on high-yield bonds and comparable-maturity Treasury bonds. Much of the volatility has been driven by the strength of current economic conditions and strong corporate earnings juxtaposed against trade war fears, Federal Reserve tightening and geopolitical concerns.
But while it’s easy to get caught up in the movement of yield spreads, it’s important to remember that in a flat-to-modestly increasing yield-spread environment, high yield bonds can generate excess returns versus high quality simply because of their higher coupons. And recent high-yield outperformance has been dominated by coupon income.
That’s one of the reasons why Federated’s fixed-income sector committee is maintaining a modest overweight to high yield despite well-below-median yield spreads. Although the ultimate low in yield spreads lies ahead, high yield does not need spread tightening to outperform high-quality fixed income. It does need spreads to not widen aggressively higher. From our perspective, the current strong economic and earnings growth environment delivers those favorable conditions.