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For fixed income investors, 2018 has been a bit of a rocky road. While the S&P 500 is up 10.3% year-to-date, the fixed income landscape has had its share of difficulties. U.S. high yield has managed to quietly miss much of the pain that has hit Emerging Market Bonds, as well as higher quality U.S. corporate bonds and U.S. treasuries. U.S. high yield, as represented by the iShares iBoxx High-Yield ETF (HYG), is up +2.09% year-to-date. Meanwhile, unhedged emerging market bonds, as represented by the VanEck Vectors JP Morgan Local Currency Bond ETF (EMLC), are down year-to-date around -11.2%. U.S. dollar-hedged emerging market bonds, using the iShares JP Morgan U.S.D Emerging Market Bonds ETF (EMB) as a proxy, while faring better were still down almost -5.6%. The difference between hedged and unhedged emerging market bonds shows how strong the U.S. dollar has been recently.
Even U.S. long-term investment grade corporate bonds have had a difficult time in this evolving interest rate environment. Using the Vanguard Long-Term Corporate Bond ETF (VCLT) as a proxy, long-term corporate bonds are down almost -6.5% year-to-date. Longer-term U.S. treasury bonds also did not escape unscathed, using iShares 20+ Year Treasury Bond ETF (TLT) as a proxy, falling almost -6.4% year-to-date. Shorter-term treasuries stumbled also, with the iShares 3-7 Year Treasury Bond ETF (IEI) as a proxy, down a bit over -1.4%. The chart below reflects total returns, year-to-date for High Yield.
So why are high yield bonds doing better than most? High yield bonds, being below investment grade, tend to be more sensitive to the economic environment, like stocks, than they are to interest rates. The high yield bond market, oddly, has been a bit of a haven this year. Traditionally not seen as such, high yield bonds have provided some insulation from rising interest rates and the strong dollar that are affecting the fixed income market this year.
Also assisting high yields with their returns this year are tax cuts, diminished supply, as well as moderately-paced monetary tightening.
Corporate profits have been bolstered dramatically by the recently passed tax cuts. These tax cuts have lifted earnings, particularly at highly leveraged firms which has allowed them to be able to better handle their debt servicing. The bottom 25% of the most highly leveraged borrowers has seen an improvement between the proportion of their debt and pretax earnings to 7.8 times in June from 8.4 times last December.
There is a favorable supply and demand dynamic developing. High yield bond prices have been supported by this. Total issuance of high yield bonds has declined 22% year-to-date versus the same period last year.
Lastly, the Fed gradual pace of interest rate increases has in effect deferred the brunt of the impact of rate increases and borrowing costs on high yield issuers. Given the strong economic data the outlook will further encourage corporate managers to continue cutting down debt servicing, further boosting the high yield market.
Even though 2018 has been challenging for fixed income investors, Hanlon continues to see potential opportunities in high yield bonds to help generate returns for investors.Download PDF
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