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The Party’s Almost Over, Say High-Yield Bond Investors

The high-yield party has been raging. But investors who stick around may have one heck of a hangover.

In recent weeks, the difference in yields between high-grade investment or government bonds and low-grade, high-yield corporate bonds dropped to 375 basis points. Often called junk bonds, companies with low credit ratings issue high-yield bonds for access to capital, although at a higher interest rate than companies with good credit.

But risk needs the right amount of reward. The shift in yields meant only 0.375% in interest now separates the safest bond investments from those issued by companies with poorer credit (and a higher risk of default). Given the narrowing yield spread, several prominent portfolio managers have decided it's time to count their winnings and bail on high-yield bonds.

"As a credit debt holder, you've got no upside, you only have downside [at this point]," says Pilar Gomez-Bravo, director of fixed income Europe for MFS Investment Management. Even if technical signals seem to indicate a rally, "at some stage you want to be prudent in your risk taking with levels you're getting paid for. You enjoy the party, the rally, the momentum, but you have to be diligent." Back in 2016, 30% of the portfolio she oversees was high-yield. Now that's down to 10%.

Getting nervous

"There is an expectation that the economy is slowing in the United States" and around the globe, said Troy Snider, investment adviser and principal at Bartlett Wealth Management. The possibility of a rate cut in the Fed's July meeting is seen as proof and the Fed funds futures are showing a 100% expectation of a cut then, according to a Fortune review of data from Bloomberg. That means investors think the Fed will respond to what it sees as a slowing economy by dropping rates in a stimulus attempt.

A slowing economy tends to be disproportionately hard on high-yield bonds. The amount of interest companies have to pay for new bonds, be it the first issuance or to roll over and pay off old bonds, shoots up. Now there's more money to be made by investors in buying a newly issued bond rather than purchasing an existing one from a current holder. Investors who already hold bonds can find themselves unable to offload existing holdings, as the market chases more profitable assets.

"You kind of think about it as a hill," said Jeff Garden, chief investment officer of Lido Advisors. "On the way up, when rates are low, it's great because [the low rates are] stimulating the economy and promoting growth. Things are looking up. The cost of business is cheap." But once at the top, things again go downhill, with a slowing economy and increasing rates. That worries investors—who doesn't like the good times to continue?—and they now assume that additional rate cuts are more signs of a slowdown.

This has left high-yield bonds are in an agitated state. In May, $7 billion was pulled out of high-risk bonds, which shouldn't matter in a trillion-dollar or larger market, according to Karissa McDonough, fixed income strategist at People's United Advisors. A trading day that saw $10 billion shifts would be considered normal, she said.

But investors still reacted strongly. As a result, the interest spread between high-yield bonds and time-matched Treasurys went up by 100 basis points, or 1 percentage point, within six weeks. "The spread reflects the extra yield that investors demand for a high yield bond instead of an asset like a Treasury bond," she said.

Then in June, Powel signaled the Fed's dovish position toward rates and another $7 billion came back into that market. Within a few weeks, the spread dropped again by 70 basis points. "The idea that some small amount flowing [into or out of] the market could move it to that degree tells you is this asset class is very, very sensitive to liquidity and fund flows and investor sentiment," McDonough said.

Risk goes up

The potential for rapid and nervous reaction now creates a risk in the higher-yield and junk bond markets. The companies issuing the bonds typically expect to roll them over, taking on new bond issuance and investors to pay off the earlier batch. "If the market pulls back and capital is not as easily accessible to these companies, it's difficult to roll over," McDonough said.

That could drive up default rates, which hurt the overall results in any portfolio, because the greater the number of defaults the lower the average returns. At the same time, there is the dichotomy between the bond markets and equities, which are high on assumptions of Fed rescue with rate drops.

"Something is about to break [in the economy] and that's why the Fed is cutting rates," Gomez-Bravo said. "When you take that in the context of the credit market, you have to overlay [whether you are] getting paid for default risk, for downgrade risk."

"Our fixed income holdings have almost exclusively been high-yield for the better part of a decade," said Patrick McDowell, a portfolio manager at Arbor Wealth Management. "We’ve done well with the strategy relative to other types of fixed income. But we are dramatically slowing our purchases."

Or, as Garden put it, "At this point in the year, when I look at the numbers, I see no reason to hold onto them. I've had a very, very healthy return, one that I don't expect to continue for the next six to 12 months. I don't expect the magnitude and trajectory of returns that I've seen over the past few months to continue, so why bother?"

Some managers say that dumping all high-yield bonds may not be necessary, but investors have to pick and choose carefully and not depend on a high-yield bond ETF, an investment fund type focused on high-yield bonds and often popular with investors who want better performance than available in government bonds. "It's time to be very selective," Gomez-Bravo said. "If you're going to have high yield, choose the idiosyncratic risk that you like."

And don't forget to have aspirin at hand the next morning. Just in case.

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