Safe bonds are out. Risky bonds are in.
As investors anticipate rising U.S. interest rates, stronger economic growth and higher inflation, ultrasafe government bonds have been slumping along with investment-grade corporate bonds.
But high-yield bonds are lapping up the improving economic outlook – and these investments should continue to bask in the good times in 2017.
It can be dangerous stuff, of course: This class of riskier corporate debt, also known as junk bonds, has not received the investment-grade stamp of approval from ratings agencies, and sometimes it's clear why.
Defaults on U.S. and Canadian high-yield bonds surged in 2016 to a six-year high of nearly 5 per cent, as energy exploration and production companies wilted under the strain of low crude oil prices.
That's up from a default rate of 3.4 per cent in 2015 and just 1 per cent in 2013, according to Fitch Ratings.
For the first half of 2016, widespread concerns that defaults would continue to climb weighed heavily on exchange-traded funds that hold a basket of high-yield bonds.
But the outlook is now turning – fast. Fitch, which had expected the default rate to rise to 6 per cent in 2016, now expects default rates will fall sharply in 2017, to about 3 per cent.
This optimistic outlook is pegged on two reasonable assumptions: The U.S. economy continues to grow slowly without slipping into recession, and the worst is over for energy companies now that the price of crude oil has doubled from its 13-year low in February.
"The 2017 rate considers that the bulk of the most severely distressed energy companies defaulted during the course of 2016," Fitch said in a recent report.
Investors appear to be onside with this view. The SPDR Bloomberg Barclays High Yield Bond ETF (JNK-N) has risen 16 per cent since February, when oil began to rebound. The iShares U.S. High Yield Bond Index ETF (XHY-T), which is hedged to Canadian dollars, has risen 15 per cent.
There is plenty more room for gains. These ETFs, which provide instant diversification across dozens of companies, remain at least 10 per cent below 2014 levels and they have distribution yields above 5.5 per cent – making them well worth a closer look.
It may seem counterintuitive to seek out bonds at a time when many observers are suggesting that the long bull-market in bonds is finally over. The yield on the 10-year U.S. Treasury bond surged above 2.5 per cent in December, up from just 1.35 per cent as recently as July.
As yields rise, bond prices fall and the asset class gets a bad name – especially as the U.S. Federal Reserve mulls additional increases to its key interest rate after bumping up the rate twice over the past two years.
But high-yield bonds are a different animal to Treasuries and investment-grade corporate bonds: They tend to follow the path of economic activity rather than interest rates.
Pimco, the global investment management firm, pointed out that high-yield bonds historically have delivered positive returns when the yields on U.S. Treasuries are rising.
Similarly, strategists at Citigroup said in November that investors should avoid investment grade bonds in an environment where the Fed is raising rates and stimulative government spending under the incoming Trump administration is set to rise. Instead, they believe investors should diversify into U.S. high-yield bonds, where the strategists have an enthusiastic "overweight" recommendation versus a lukewarm "neutral" recommendation for U.S. stocks.
Now, with energy companies on the mend as the price of crude oil stays above $50 (U.S.) a barrel, there is every reason to believe that high-yield bonds will continue to perform well.
According to Fitch, energy companies accounted for 15.5 per cent of defaults for the 12 months prior to September. If this default rate falls, high-yield bond ETFs should benefit.
You could, of course, snap up energy bonds specifically, but that's not so easy for retail investors and it does expose you to the risks of a particular company.
Another approach is to take a flyer on an ETF that has specialized in high-yield bonds that have been downgraded. The new iShares Fallen Angels USD Bond ETF (FALN-Q) does just that: Its 131 different bonds – nearly 30 per cent from the energy sector – were once investment-grade.
They could become investment grade again, if things go right. Until they do, the distribution yield is 6.3 per cent.
David Berman