Stocks aren’t the only cross section of risk assets getting shellacked this year. In fact, high-yield bonds were in all likelihood a strong warning indicator for trouble ahead prior to the August swoon. This sector of the fixed-income market has become highly sought after by retired investors who rely on their portfolio to generate income on a monthly or quarterly basis. But should it be?
These same investors will likely face some tough challenges ahead. Especially with decisions like whether to invest for above-average yield or total return; since one strategy is bound to significantly outperform the other.
Here is the crux of the issue: If you are a retiree seeking to withdraw the average of 4% per year, would you feel more comfortable in an investment-grade index yielding barely 2%? That assumes a moderate amount of interest-rate risk and the reliance upon capital appreciation to reach your withdrawal target.
Or would you prefer to invest in high-yield-bond indexes yielding 6%-plus and take your chances with an uptick in credit losses or continued underperformance?
Examining the performance of high-yield bond indexes such as the iShares High Yield Corporate Bond ETF HYG, +0.12% and SPDR Barclays High Yield Bond ETF JNK, +0.03% it’s clear they began to tail off in the June. This price action followed the resurgence from 2014’s credit malaise, while equities managed another few months of sideways oscillation.
It’s been a tough few years to own domestic junk bonds as a result of oil-price volatility and the subsequent repricing of many fringe companies within the sector. Even active managers have had their hands full attempting to strategically allocate their portfolios through a minefield of negativity and steadily falling prices.
The bottom line is that if history is any guide, we are overdue for more prolonged underperformance in funds like HYG and JNK. I think we can all agree that if the economy stays on the rails into year end, the Federal Reserve will have little choice but to raise interest rates at least a quarter point to begin their first tightening cycle since 2006. Examining the correlation between previous tightening cycles and junk-bond yields, it’s clear that riskier bond yields rise (and prices fall) as a result of the reshuffling at the shorter end of the curve. That may ultimately boost the appetite for higher-quality bonds on the longer end of the curve.