The high-yield corporate bond market has had a spectacular run for nearly five years. Average annual returns have been near 15%, corporate balance sheets have strengthened, and default rates have dropped from the mid-teens during the financial crisis to between 2% and 3%.1
The improving outlook for high-yield bond issuers and the challenging environment for income investors have helped to drive strong demand—more than $200 billion has flowed into high-yield funds over the past five years.2 This demand has pushed down yields: The average high-yield bond carried a yield of just 5.3% as of late February, compared with around 20% in 2008 and early 2009. Matthew Conti, portfolio manager of Fidelity® Focused High Income Fund (FHIFX) and Fidelity® Short Duration High Income Fund (FSAHX), notes that while yields are not at historic lows, they’re close, and the average high-yield bond trades above par value.
High prices and historically low yields might seem to indicate that high-yield fixed-income investors should start looking elsewhere. Not so fast, says Conti. “While the double-digit price gains of recent years are likely a thing of the past, I think the coupon interest from the bonds may lead to another two or three years of strong performance in the high-yield market,” he says. “At the same time, investors should consider the risk of rising rates, and consider short- duration strategies.”
Low yields don’t tell the whole story
Conti acknowledges that yields on high-yield bonds are near historic lows. But he points out that these bonds still offer considerably more income than other fixed-income categories for investors prepared to accept the greater volatility and risk historically associated with investing in lower credit quality securities. In particular, he notes that the yield premium offered by high-yield bonds over Treasuries remains in line with historical averages. “Spreads are very much in the range of where we’ve been during a mid-cycle recovery,” he notes. “So high-yield bonds offer more value to the investor than their absolute yields might imply.”
High-yield spreads have tightened somewhat as Treasury rates have increased over the past year. Conti says they could tighten more if rates continue to rise. Such a scenario might be particularly relevant if the rate increases are driven by an improving U.S. economy that strengthens corporate balance sheets—leading investors to likely demand less of a premium for investing in these bonds.
Conti says investors should expect returns in the high-yield market to come from the interest paid by the bonds rather than from price appreciation. Still, he says, “I think these bonds may do relatively well. Historically, high yield has done very well in rising rate environments relative to investment-grade bonds.”
A calm forecast
There’s no guarantee that the U.S. economy will maintain its gradual improvement, of course. Worsening conditions in emerging markets or a misstep from the Federal Reserve could deal a setback to the recovery and the credit markets. But Conti argues that the high-yield market could hold up better than it has during previous recessions.
One reason is that over the past several years, below-investment-grade borrowers have taken advantage of low rates to refinance their debt, and in the process they have pushed maturity dates on their bonds further into the future. Today, the average bond in the high-yield market doesn’t come due until the end of the decade.
Until their bonds mature, issuers just have to meet interest payments to avoid default. “This provides the high-yield market with a long runway before you would expect to see a substantial increase in the default rate,” explains Conti. “Even in a downturn, it is difficult to default if you don’t actually have to pay off your debts.”
This is a marked change from 2008 and 2009, when concerns mounted over the ability of companies to manage their debt. “Most high-yield companies can’t simply pay off their debts, so they rely on the credit markets to let them roll their debt into new bonds or securities,” says Conti. “Back then, people worried that companies with debts maturing in 2015 and 2016 would have a difficult time refinancing. That kind of maturity wall is much less of an issue now.”
The short-duration solution
Relying on yields for return makes investors more vulnerable to interest rate risk. One way to minimize this risk is through the use of short-duration high-yield bonds. “One of the biggest risks to all kinds of fixed-income securities is rising interest rates,” observes Conti. “Holding the shorter-duration part of the high-yield market naturally limits exposure to interest rate risk.”
Short-duration bonds also carry somewhat lower risk of default than longer-duration securities, in part because issuers tend to prioritize payments on bonds closer to maturity. Moreover, investors can have greater confidence in their analysis of shorter-term securities. “When you buy a ten-year bond, which is the typical maturity for the broader high-yield market, you have to project cash flow out over the life of the bond—but you can’t have much confidence in your projections more than a few years out,” explains Conti. “You can have much greater confidence in your cash flow projections over the next two or three years.”
The trade-off for reduced risk is lower yield. A short-duration high-yield bond today may yield 3% or 4%, says Conti, compared with 5.3% for the overall high-yield market.3
Conti notes that short-duration high-yield bonds can complement investment-grade bonds, offering a lower-risk way to increase the yield of a fixed-income portfolio than adding longer- duration high-yield bonds. “Short duration also may be an alternative for investors looking at leveraged loans and bank debt,” he says. “Short-duration high-yield bonds have recently offered a slightly higher yield and return profile than the bank debt segment of the market.
“Given my outlook for relatively low default levels, interest rate increases appear to be the most likely risk for high-yield bond investors,” adds Conti. At the company level, he sees reason for optimism: the financial outlook is good, companies are deploying cash intelligently, and for many issuers refinancing is a distant concern. “I think we have two to three years of this mid-cycle recovery,” says Conti. “Although we’ve had five years of phenomenal returns in the high-yield market, I don’t necessarily expect that to continue. But I also don’t see a change in the underlying composition of the market that would lead me to think we’re going to have a fundamental correction.”
- Learn more about the funds Matthew Conti runs: Fidelity® Focused High Income Fund (FHIFX) and Fidelity Short Duration High Income Fund (FSAHX), and Fidelity’s other high-income funds.
- Check out Fidelity’s tools for individual high-yield bonds.
- Find other bond funds with our mutual fund research.
- Find out more about fixed-income investing.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917