Aim for a high income with a quality screen
By Kevin Flanagan
With U.S. interest rates rising this year, and in some cases from near zero levels, investors faced a fixed income landscape not seen in several years. . I wrote about this in a blog post a a little over a month ago and wanted to update the story.
This article will highlight specific developments within the US high yield (HY) arena this year. Heading into 2022, a definitive argument could have been made that HY fixed income securities were expensive, with spread levels ending last year at a narrow +300 basis points (bps). Since then, HY spreads have increased and at one point in early July reached just under +600bps, almost doubling in just over six months.
High Yield Credit Spreads, 01/02/15-08/17/22
Since then, the HY market has gone from one of the worst performers in the US bond universe to one of the best. To give perspective, HY was posting a year-to-date return of -14% in early July, but this has since improved by almost half to -7.7%, at the time of this writing. Compare that to the benchmark Agg, where year-to-date performance over that same period has remained in the range of around -9% to -10%.
Let’s go back to the “income” part of the equation. The HY yield at worst (YTW) is now around 7.60%, up almost +340 basis points since the start of the year. As recently as July last year, the YTW was only around 3.50%. Interestingly, the US high yield market rallied in the wake of weaker data suggesting the economy is in a “technical recession”. This level of return puts HY in its more well-known traditional role of “income provider” in bond portfolios, and could help explain this recent rally, as well as being a sign that barring a deep downturn, the HY market has already reduced Fed-induced economic weakness. It should be noted that even with its recent outperformance, HY spreads are still moderately above the median level of +403bps over the last 7.5 year period.
High Yield Cumulative Defaults, 3/31/16-6/30/22
With concerns about recession and potential risk aversion remaining a prominent part of the investment landscape discussion, an HY solution that recognizes this factor is an important consideration for investors. The WisdomTree U.S. High Yield Corporate Bond Fund (WFHY) uses a “quality screening” approach that focuses only on public issuers and their associated balance sheets. We have found that eliminating the universe of public issuers with negative cash flows can serve as an important quality screen and help address elevated credit risk apparent in the market capitalization-weighted approach, the objective being to mitigate credit problems, ie the risk of default, which can arise from risk-free periods (recessions). As shown in the chart above, the default rate for US market cap HY has been 13.2%, while for WFHY it has been only 2% since inception.
The core message is that “there is income in fixed income”, but the current market environment has made it clear that a strategy that emphasizes fundamentally sound companies with strong cash flows cash is prudent in times of economic uncertainty.
Important risks related to this article
There are risks associated with investing, including possible loss of capital. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. High yield or “junk” bonds have lower credit ratings and involve higher principal risk. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will not pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments causes the price of that bond to fall. Although the Fund attempts to limit credit and counterparty exposure, the value of an investment in the Fund may change rapidly and without warning in response to issuer or counterparty defaults and changes in credit ratings investments in the Fund’s portfolio. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.
Kevin Flanagan, Head of Fixed Income Strategy
Within WisdomTree’s Investment Strategy Group, Kevin is responsible for Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes content related to fixed income and travels with the sales team, organizes client meetings and provides expertise on existing bond ETFs and future of WisdomTree. Additionally, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently Chief Executive Officer. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. Contributed to Morgan Stanley Wealth Management’s Global Investment Committee, lead author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and worked with divisions of the firm’s Research and Advisory Group to create asset allocation models for ETFs and fund managers. Kevin holds an MBA from the Lubin Graduate School of Business at Pace University and a BS in Finance from Fairfield University.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.