Is the risk/return tradeoff still favorable for high-yield bonds?
High yield bonds have had a nice run the past few years, but we still think there's upside and that high yield bonds will out perform other fixed income asset classes over the next twelve months. When determining our high yield out look, there's four factors that we consider. The economy, corporate credit quality, technicals and valuation. First on the economy, simply stated, we think the economy's in great shape and that it will continue to expand at a healthy clip for the foreseeable future. On corporate credit quality the default rates are near all time lows. We expect them to remain at these low levels giving the strength and the growth of corporate profits and cash flow. Third factor it, technicals and we think technicals are favorable. On the demand side there's still a global search for a yield out there and on the supply side, net new issuants of high yield bonds are expected to remain low. Finally, valuation. High yield spreads are inside the historical medium, which does temper our outlook a little bit. However, if you look over the past 30 years, and look at past credit cycles, you'll see that high yield credit spreads still have room to tighten and they can remain at very low levels as long as the economy is healthy.
How have high-yield bonds performed in rising-rate environments?
Historically, high-yield bonds have done very well in periods of rising interest rates. Over the past 25 years or so, there have been 10 periods of rising rates defined as the 10 year U.S. Treasury increasing by about 100 basis points over the course of about a year. In each one of those 10 periods, high-yield bonds have generated positive absolute returns and have significantly outperformed higher-quality bonds. This may see counterintuitive, because you might expect companies with the most debt to underperform in periods of rising interest rates, but you need to remember why rates typically rise in the first place, because the economy's expanding, and profits are growing. Markets go into risk-on mode in these environments, so you get spread tightening and equity multiple expansion. This is the ideal environment for risk asset classes such as equities and high-yield bonds.
Views are as of 3/15/2018 and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices. High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risks, and may be more volatile than investment grade securities. Federated Investment Management Company 18-73700 (3/18)