Randy Steuart is the portfolio manager of the Ewing Morris Flexible Fixed Income Fund.
In the traditional corporate bond world, year to date returns have been ugly. For example, the largest corporate bond ETF, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), has delivered a negative 3.5-per-cent return so far this year. Investors are likely asking themselves, "I was only expecting a 3-per-cent return, why should I be down 3 per cent to 4 per cent already?"
Indeed, this is a good question. Sure, it's been a difficult ride in fixed income since rates started to rise in 2016, but it is important to pay attention to the encouraging fact that not all parts of fixed income have responded to rising rates in the same way. Rates started to rise in July, 2016, and we've seen a stark difference in performance of two parts of the corporate bond market: the investment grade bond market, which is composed of bonds of very high credit quality (credit ratings of triple-B and above) and the high-yield bond market, which is composed of bonds with medium- or low-credit quality (below triple-B credit ratings). Since this time, high yield's bellwether fund, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), returned 10.5 per cent, while investment-grade bond returns (as measured by LQD) have been negative 0.5 per cent. The 11-percentage-point performance gap is meaningful and is contrary to the opinion that all bonds fare poorly in rising-rate environments. What, then, explains this difference?
In order to accept credit risk, corporate bond investors typically demand additional compensation compared with a risk-free government bond (termed "credit spread"). In rising-rate environments, corporate outlooks typically brighten and bond investors' willingness to accept lower credit spreads serves to offset rising rates, which explains why high yield bonds, in particular, tend to outperform when rates rise. High yield bonds aren't your ordinary fixed income investment.
Despite its track record, many investors dismiss high yield because it is simply deemed to be a "low quality" space. Investing in "high quality credits" might be an effective marketing pitch; however, it is not an investment strategy because it pays little regard to valuation. Given the low interest rates we saw in 2016, the investment-grade bond market was being undercompensated for the chance of rates rising. This wasn't the case with high yield, as the 11-per-cent performance gap demonstrates.
Unfortunately, many investors conflate the quality of a company with the quality of its bonds as an investment. This "quality" mindset is a reasonable approach for long-term stock investments, but it is far less useful for fixed-income investments. To bring this "quality" distinction to life, consider Johnson & Johnson. A global industry leader, Johnson & Johnson holds commanding market shares across numerous medical and everyday consumer product lines. The company is fantastically profitable, has a sustainable competitive advantage and, most importantly, is one of a handful of companies that remains triple-A rated, the highest-quality credit rating available. Despite all these marketable attributes, since rates started their ascent in July, 2016, the price of J&J's 3.55-per-cent bonds due March, 2036, fell by about 14 per cent. When taking the bond's interest income into account, investors lost 8 per cent. Clearly, a triple-A rating does not always produce a triple-A investment result.
Now, consider a bond of a "medium quality" company: L Brands Inc. L Brands is best known for its Victoria's Secret business unit, which produces the majority of the company's profit through the retailing of lingerie. At about US$17-billion in value, the company is substantial. Importantly, of this total value, less than 30 per cent is in the form of debt – a very manageable debt load. Granted, the credit quality of L Brands is no J&J as it carries a double-B rating, but it should be noted that the double-B default rate has averaged only 0.7 per cent since 1981 – hardly something to be nervous about. Despite this modestly higher credit risk, L Brands' 6.875-per-cent senior notes due November, 2035, boasted a yield of about 7 per cent, providing a generous amount of compensation for the extra credit risk taken. And this extra yield provided a cushion for the investment: It allowed the bond to better absorb interest rate changes. Over the same period of time that the JNJ 2036 bonds lost 8 per cent owing to rising rates, L Brands' bonds delivered a 9-per-cent return because of its higher income production and reasonable valuation. What a difference "quality" makes.
The high-yield bond market comprises only 3.5 per cent of the shelf space in the North American fixed income supermarket, but for the few locals who know how to shop that aisle, there still remain bonds that can produce all-weather results.