What Is Brewing in the Junk Bond Market and Will It Impact Investment Grade Corporates?

As measured by the popular high yield ETF “HYG,” high yield bonds fell 3.8% last week. Financial market volatility, the continued downturn in the price of oil, and news that a prominent high yield mutual fund and multiple credit hedge funds are closing to redemptions and/or shutting down triggered the sell-off. For months we have heard from many well-known investors that the high yield bond market was ripe for a correction. As rates have stayed low over the past few years, investors have reached for yield by investing in lower credit quality securities. With the Fed set to raise the Fed Funds Rate for the first time in 9 years, investors are questioning whether the yield reach has become a crowded trade. Couple this with the fact that 25% of the high yield bond market is energy related, and investors are now running for the exits. What impact will this have on investment grade bonds? Some, but the volatility for investment grade corporates will likely be much lower. And if government bonds like Treasuries are added to the mix, lower still. The 10 year historical returns correlation between the BofA/Merrill Lynch High Yield Index and the BofA/Merrill Lynch 1-10 year A-AAA Investment Grade Index has been 0.60. The correlation between the High Yield Index and a broad taxable index that has a 70% weighting to government bonds has been 0.09. Municipal bonds versus high yield is 0.22. So, when the world is talking about junk bond volatility, know that our investment grade portfolios are performing quite differently.

Sources: BofA/Merrill Lynch, WSJ