ARTICLES JANUARY 2019
Are fixed income investors more concerned with interest rates or credit risk? For much of 2018, that answer was pretty obvious. Bond yields (which move inversely to prices) climbed as the Federal Reserve forged ahead with gradual interest rate hikes.
Indeed, concern that accelerating growth might prompt the Fed to raise rates more sharply helped spark an equity market correction in early 2018, and a steep rise of short-term bond yields in the interim.
Now, credit risk is coming into sharper focus for investors. Credit markets began to adjust in late 2018, when jitters about a global slowdown gripped markets and prompted the gap between credit and U.S. Treasury yields to widen. Fast forward to the present: For both investment-grade and high-yield bonds this gap — known as the credit spread — is at a nearly two-year high. In contrast, short-term Treasury yields have plateaued in recent months.
Looking ahead, credit spreads could widen more substantially in 2019 as investors demand additional yield as compensation for credit risk. “Concerns about interest rate risk are often front and centre for investors during a rate hike cycle,” says Mike Gitlin, head of fixed income at Capital Group. “But it’s important to note that while Treasury yields have already climbed, credit spreads remain relatively tight. Until valuations become more attractive, a degree of caution around credit seems appropriate.”
In 2019, there’s good reason to anticipate more fragile investor confidence in credit, equities and certain other “riskier” asset classes. After all, stocks and corporate bonds had been on a tear for much of the past decade and most developed economies have entered the later part of their economic cycles.
Consider the U.S. economy. The unemployment rate recently hit 3.7% — the lowest in nearly three decades. Moreover, the number of job openings now exceed the number of unemployed Americans. Add to that the multi-decade peaks we’ve seen for consumer confidence and corporate debt as a percentage of GDP. In short, the U.S. is showing all the classic hallmarks of being late-cycle.
Changing expectations about the likely path of the Fed’s monetary policy in light of evolving economic data likely will add to late-cycle volatility. And not just because of rate hikes; the Fed’s changing balance sheet also matters. After nearly a decade of extremely accommodative policy, the Fed has moved from buying assets to stimulate the economy (quantitative easing) to selling those assets (quantitative tightening).
“Quantitative easing was an experiment. Quantitative tightening is also an experiment,” explains John Smet, fixed income portfolio manager. “We think it's going to lead to more volatility, and riskier parts of the bond market doing poorly. We've just started to see some of that.”
High yield has notched some of the highest returns in fixed income over recent years. Consequently, high-yield spreads are relatively tight, or in other words, valuations are high in historical terms.
If history’s a guide, high-yield investors should be prepared for a more challenging return environment over the next couple of years. When spreads have been close to recent levels, the subsequent returns for high yield have at best modestly outpaced U.S. Treasuries.
Historically, when high-yield spreads have been in their tightest quartile, Treasuries have returned 4 percentage points more, on average, over the following two years. Even in the second quartile, high-yield returns on average were near those of Treasuries.
Taking on significant credit risk for the potential of only incremental additional return does not seem like a good tradeoff. Also, unlike Treasuries and other high-quality bonds, high yield tends to be tightly correlated to equities. Instead, a more favourable choice may be high-quality bonds that can better withstand equity volatility. A key role of your bond allocation is to stabilize your broader portfolio.
Amid unsettled equity markets, it’s important for investors to be mindful that high yield can be a source of meaningful portfolio volatility. For those with a lower tolerance for volatility, a relatively limited high-yield allocation may be worth considering.
Also critically important is being on the lookout for unintentional credit risk in core fixed income allocations. Unfortunately, some core bond funds have prioritized boosting income over diversification and preservation. “Reaching for yield” often entails heavy investment in high yield.
We believe that fixed income should seek to deliver balance to an overall portfolio by offering elements of all four of its key roles: diversification from equities, income, capital preservation and inflation protection.
With prospects for high yield now on shakier ground, some investors have turned to floating-rate bank loans. That’s because rising interest rates tend to provide a tailwind to the income paid by this form of debt, also known as leveraged loans.
And yet, just as with high yield, valuations in floating-rate bank loans aren’t necessarily that attractive given the credit risk entailed. Investors often have to accept lower quality, weaker credit fundamentals and less creditor protection in the event of default than with high yield.
In comparison, investment-grade emerging markets debt can be an attractive allocation option for investors who want to complement corporate high yield and diversify portfolio income. It can provide a similar level of income as floating-rate loans or high-yield bonds. However, they also come with historically lower correlations to equities and higher credit quality.
Investors in investment-grade emerging markets debt do have to accept a greater interest rate risk (as measured by duration). But if you don’t expect interest rates to go through the roof, this area of the bond market could be worth exploring.
Mike has 24 years of investment industry experience and joined Capital Group in 2015. Before joining Capital, Mike was the head of fixed income and global head of trading for T. Rowe Price.
Chad specializes in tax-exempt bonds. He has 25 years of investment experience, 13 with Capital Group. He holds an MBA from the University of Chicago and a bachelor's degree from Marquette University.
John has 36 years of investment experience, 34 with Capital Group. He has covered mortgage-backed securities and railroads. John earned an MBA in finance from the University of Wisconsin and is a CFA charterholder.