Given we are in the summer doldrums we decided to mix things up for the weekly commentary. We hope this is not too much. If you get through it and have questions or concerns don’t hesitate to contact us.
Indices for the week and YTD are as follows:
- S&P 500 up .86% for the week; YTD index return is 7.46%
- NASDAQ Composite up 1.66% for the week; YTD index return is 14.88%
- Dow Jones Industrial Average up .47% for the week; YTD index return is 4.31%
- Benchmark 10-year Treasury bond yield stands at 2.81% - down 5 basis points on the week
We have advocated all along that clients should have exposure to high yield bonds in the fixed income portion of their portfolios. High yield bonds are also referred to as non-investment grade bonds and junk bonds. Given the current rate environment high yield makes sense from an income perspective, and given the positive economic environment high yield (or junk bonds) have also offered better appreciation than their investment grade cousins. Historically high yield bonds have been highly correlated with domestic small capitalization stocks. In our asset allocation models we suggest investing up to 10% of the fixed income allocation to high yield bonds. To that end we wanted to share some commentary, and a few slides that came out of a recent CFA Institute conference sponsored by the New York CFA Society earlier this summer.
For some perspective the current default rates (2018) on corporate grade and junk bonds are running .8% and 1.7% of issues respectively. The historic average annual default rate on investment grade debt has been 1.6% for the past 35 years and around 4.2% for junk bonds over the same period.
Default rates for investment grade issues have been higher since the Great Recession until recently and are now trending below historic averages. Default rates picked up for commodity (think energy) issues beginning in 2015 as energy prices collapsed but default rates have recently trended downward. Also, the retail sector has experienced high default rates (7% in 2017) and is also moving lower. We have some additional information on the retail sector below.
The takeaway is that the probability of default on corporate bonds including high yield bonds is low even in bad years. Consequently, we spend more time focusing on yield, pricing, and bond volatility than on credit. That said, we are currently looking at A rated bonds or higher for individual investment grade purchases that we show trust officers.
Below is commentary to accompany the charts and spreadsheet attached above.
Chart on U.S. Rating Distributions – This chart looks at the quality rating distribution for corporate issues with the exception of a couple issuer types. The chart looks at the changes in the quality rating distribution over the past ten years.
Spreadsheet on U.S. Rating Distributions – at the bottom are a few observations we have made after analyzing the chart, including the bulk of ratings fall between A and B-; there has been a slight shift from mid-investment grade quality to mid below investment grade issues.
Chart on Higher Beta generally outperforming over last 12 months (higher beta means assets with higher risk relative to the market). The chart is fairly self-explanatory – note that IG means Investment Grade; HY means High Yield; EM means Emerging Markets.
We found the chart on rating downgrades of the debt of retailers since January of last year telling. A lot of the downgrades are a result of retailing moving to the internet via Amazon, and supports the high retail sector default rate noted above.
The final slide is simply some comments by the participants at the conference in regard to retailers.
One final note, a Barron’s article (08.20.18 pg. 29) says that the issuance of BBB+, BBB, and BBB-rated debt has risen to $3 billion currently from $700 million in 2008. The total corporate market domestically is between $8 billion and $ $9 billion – so about 1/3 of the market sits in lower investment grade debt.
The fear is that as the economic expansion plays out and we move towards recession these bonds could be downgraded to “junk”. Whether this scenario plays out is anyone’s guess. However, earlier this year the investment area decided to focus on buying A rated debt and above, and letting our lower investment quality bonds “run off” (in English – mature). 40%+ of the bonds we hold (this now includes all issues not just corporates) are in the BBB+, BBB, BBB- range. The article also states that the yield pick-up (i.e. higher yield) of a BBB versus an A rated bond is only 60 basis points and not worth the risk given the possibility of a down grade of the BBB bond to junk status.