Does steep drop in assets signal an entry point or a correction?
The recent sell-off across the high-yield bond space has whetted the appetite of active bond traders but put longer-term investors more firmly on the sidelines, creating a kind of mixed message for the market.
“We definitely viewed the huge outflows over the past three or four weeks as a buying opportunity,” said Michael Collins, a senior investment officer with Prudential Fixed Income. “Buying on the dips is what you're supposed to do, and that's what we're doing.”
High-yield bond mutual funds experienced more than $7.8 billion in net outflows in July, which followed $467 million in net outflows in June. The sudden burst of outflows followed nine consecutive months of net inflows into the category, according to Morningstar Inc.
Analysts and portfolio managers attribute the sell-off to a combination of factors, including increased geopolitical risks and the tightening of yields spreads between high-yields and Treasury bonds, which means investors are being paid less for the risks associated with below-investment-grade bonds.
“This kind of sell-off should be a good reminder to investors that high yield can be a good source of income, but it is also an asset class that comes with risks,” said Matthew Tucker, head of fixed-income strategy at BlackRock Inc.
He cited an average yield spread over five-year Treasury bonds of just 3.23 percentage points, which is the lowest level since 2007, when the spread dipped to 2.75 percentage points.
“Over the past 20 years, the spread has been around 5.5 percentage points,” Mr. Tucker said.
But even as nervous bond investors have started exiting the market and yield spreads have started to widen slightly, Mr. Tucker is not convinced high-yield bond prices are at entry-point levels yet.
“I think investors have gotten more cautious on high yield as an asset class,” he said. “You might see some rallying at this point, but it will be limited. Although the market saw a sell-off, we're still cautious.”
James Lee, senior fixed-income analyst at Calvert Investments, agrees the sell-off was triggered in part by investor jitters, but added the market could also be experiencing some basic profit-taking.
“We've had a good year in high yield and performance has been largely positive until the sell-off two weeks ago,” he said. “To some extent, I think investors were saying, maybe we're in a toppy market.”
But whether investors were responding to geopolitical risks or valuation levels, Mr. Lee doesn't believe the high-yield-bond space is flush with hidden risks at this point in the cycle.
“In general, high-yield companies are doing well,” he said, citing analysts' average default expectations of around 2%, which compares with a 30-year average default rate for high-yield bonds of nearly 6%.
In many respects, high-yield bonds are hybrid asset class that typically trades in sync with equities, but will also react to interest-rate movements.
“The question becomes is high yield rolling over because there is some sort of business cycle change, or it is just a correction in the markets?” said Scott Colyer, chief executive and chief investment officer at Advisors Asset Management.
“I can't imagine it's anything other than we're starting to see a correction in the market,” he said. “First small caps corrected, and now high yield is correcting, and we think it's the beginning of a buying opportunity for an area that is selling off because it was incredibly overbought.”
