Not even three full months into 2022 and it’s clear that one of advisors’ and clients’ primary concerns is the rapid erosion in the bond market at the hands of rising interest rates – a scenario that’s prompting some clients to feel as though there’s nowhere to turn in the fixed income space.
Fortunately, there are some shelters from the bond market storm and some of those ideas are likely to surprise clients. For example, some market observers are highlighting high-yield corporate debt, also known as junk bonds, as an avenue for surviving the Federal Reserve’s recently commenced tightening regime.
Indeed, that’s a grin and bear it proposition for clients because the Markit iBoxx USD Liquid High Yield Index – one of the most widely followed gauges of junk bonds – is off 6.54% year-to-date while the Bloomberg US Aggregate Bond Index is lower by 6.11%.
Obviously, there are still nine months left in 2022 in which junk bonds can get their respective acts together and benefit clients. Low default rates could help the cause as can some other factors.
Why Consider Junk Bonds Today
Persistent inflation confirms this is far from a perfect economic setting, but the U.S. economy is sturdy enough to support the high-yield corporate bond thesis.
“Factors favoring high-yield bonds should be an economy that remains strong even as it cools off from last year’s post-pandemic surge, high yield’s lower sensitivity to rising interest rates, and of course, their yield advantage over higher-quality corporate and government bonds,” notes Morningstar analyst Dave Sekera.
As noted above, default rates – a major factor to consider with junk bonds – are low as are yields on investment-grade debt. With clients needing higher levels of income, some exposure to high-yield corporates could be appropriate. Additionally, there’s some value to be had in the junk bond universe and it’s likely easier to locate than it is in the world of equities.
“Looking forward, we continue to think there is value in corporate bonds, especially high yield. The main reason is that our U.S. economics team continues to forecast relatively robust economic growth in the United States over the next three years,” adds Sekera. “Our forecast for real U.S. gross domestic product in 2022 is 3.7%, which is then projected to step down to 3.3% in 2023 and 2.8% in 2024, each of which is higher than both street consensus and the Federal Reserve’s projections.”
Credit Spread Clues
Advisors know about credit spreads – the yield premium over equivalent maturity U.S. Treasuries investors receive for taking on added credit risk. However, many clients aren’t aware of this and it makes for a good conversation starter regarding why some junk bond exposure could be appropriate as 2022 moves forward.
“In our investment-grade index, the average credit spread has widened 33 basis points thus far this year. In our high-yield index, the average credit spread has widened 60 basis points,” concludes Sekera. “The widening credit spreads have contributed to the losses in corporate bond indexes this year. Yet the amount that credit spreads would widen from here should be mitigated by our expectation for robust economic growth over the next three years.”
The point: Year-to-date performance indicates advisors don’t need to over-allocate to junk bonds, but the factors highlighted here also confirm the asset class shouldn’t be outright ignored, either.
Related: Finding Bonds That Aren’t Heavily Correlated to Stocks