(PUB) Investing 2016

20

High-Yield Rallies Income Strategist | Sumit Desai

887 basis points on Feb. 11 , 2016 —the sector’s 8 . 3% yield still appears attractive relative to other fixed- income asset classes. What’s more, most sectors of the economy outside of energy and other commodities seem to be doing just fine, and most of the risk in commodity sectors may already be priced into the bonds. On the other hand, there are some obvious risks lurking that investors should be aware of. The energy sector remains a wild card, and the viability of many energy- sector bonds will depend on oil prices, which are largely unpredictable; widespread defaults are still a strong possibility in this sector. Further, valuations outside of energy are less attractive. While the overall high-yield market yields 8 . 3% , yields excluding energy, metals, and mining are closer to 7% . And, while the U.S. economy seems to be chugging along, individual companies within the high-yield sector still present idiosyncratic risk. For example, companies like Sprint S and Valeant VRX (two of the largest issuers in the market) both face company-specific issues that threaten the value of their bonds. While high-yield bond funds won’t help you diversify away from equities, income-generation and long- term return potential still make them an interesting choice to include in a well-diversified portfolio. Over the past 10 years through February 2016 , open-end high-yield bond funds returned about 5 . 6% annualized versus 6 . 8% for the S & P 500 , but high-yield bonds gener- ated better risk-adjusted returns because of about 33% less volatility than stocks. Given the asymmetric risk in the sector (limited upside and unlimited down- side), investors looking for high-yield exposure with less default risk and volatility should consider man- agers with a record of focusing on the higher-quality portion of the market. Across high-yield bond funds in the Morningstar 500 , Vanguard High-Yield Corporate Fund VWEHX , with a Morningstar Analyst Rating of Silver, and Bronze-rated PIMCO High Yield PHYDX are two strong options that fit the bill. K Contact Sumit Desai at sumit.desai@morningstar.com

Few asset classes cause as much investor confusion as high-yield bonds. Because they are in fact bonds, many investors may expect these investments to provide safety during times of market distress. However, unlike Treasury and other high-quality bonds that typically fulfill this role, high-yield corporate bonds tend to be correlated closely with equities and are more likely to suffer losses in sympathy with stocks during market sell-offs. The stunning collapse of Third Avenue Focused Credit TFCIX in Decem- ber 2015 also did little to ease investor concerns about high-yield bonds, though we continue to believe that situation was an isolated incident and that traditional high-yield bond funds are unlikely to experience a similar fate. yield bond Morningstar Category. Over the year, the Bank of America Merrill Lynch U.S. High Yield Master II Index fell 4 . 6% , compared with a positive 1 . 4% for the S & P 500 and a 0 . 6% gain for the Barclays U.S. Aggregate Bond Index. Most of the pain came from CCC rated bonds, which land at the lower-quality end of the high-yield market, and energy and other commodity-related issuers. Higher-quality fare, bonds with BB and B ratings, performed better on average but were not immune to losses. Sharp outflows from the sector coincided with this sell-off. Early March gave the sector a bit of a reprieve as inflows turned sharply positive and high-yield bonds rebounded sharply. Still, the outlook remains mixed. Bullish investors suggest that high-yield bonds rarely post two consecutive calendar years of negative returns, so the poor returns of 2015 would indicate the asset class is due for a rebound. And, while spreads narrowed recently to around 674 basis points over Treas- uries—compared with a post-financial-crisis high of There’s no denying that 2015 was a difficult year for even the most conservatively run funds in the high-