Economics

Diving For Treasure In US High Yield Requires Skill

Bonds in the US high-yield market are as varied as the creatures in the sea. Invest carelessly, and you may get stung. But with careful analysis, investors can uncover gems at any stage of the credit cycle.

[REITs]

US high-yield market
Image source: DonkeyHotey – Flickr

We strongly believe that high yield belongs in a diversified portfolio. But tracking a broad benchmark isn’t the best way to get exposure. Passive strategies ensure that investors end up owning every security and sector in the index—the good, the bad and everything in between.

That’s risky, because a market downturn or sudden shock tends to hurt the lowest-quality securities and most indebted sectors the most—think energy-sector companies between 2015 and 2016 and telecoms from 2000 to 2002. And the companies that have issued the most debt become the biggest weights in a high-yield index.

Active managers have the flexibility to seek out value and limit risk. That’s something investors should always want. But it’s especially important today. High-yield bonds, like equities and other risk assets, look somewhat expensive, and the issuers with the weakest balance sheets may struggle in a higher-interest-rate environment.

A Deep Dive to Find Value

Even so, there are still plenty of opportunities to be had. You just have to know where to throw your line. That starts with a broad sector-by-sector approach to the market, followed by a deeper dive into individual securities.

Some sectors today have the wind at their backs, while others look less attractive from a credit or valuation perspective. The following areas look attractive today:

Homebuilders stand to benefit from continued improvement in the US housing market, and several companies in the sector may even see their credit ratings rise into investment-grade territory in the years ahead.

Banking fundamentals are strong, and large diversified banks are continuing to bolster their balance sheets.

Wireline telecoms are another attractively valued sector. While their bonds have underperformed lately, these companies have sufficient cash flow and plenty of levers to refinance debt that’s due to mature in the near and medium term.

We’re less enamored of these sectors:

Gaming is a highly leveraged sector, and many outstanding bonds are undercompensating investors for their risk.

Technology has high cyclical risk, and companies in the sector have issued a substantial amount of debt over the past few years. That raises some red flags, particularly with the long-term viability of their business models in question.

Food and beverage is widely viewed as one of the higher-quality sectors of the high-yield market. But that’s driven valuations to unattractive levels. And with rates rising, issuers may be reluctant to call existing bonds, exposing investors to extension risk.

Of course, top-down sector analysis, while valuable, isn’t enough. Skilled managers should also be looking at bonds from the bottom up, individual security by individual security, to find the most promising opportunities. At this late stage in the credit cycle, it pays to be selective. The recent bankruptcy filing at Toys “R” Us is a helpful reminder of that.

Diversification is also important. That’s why it also makes sense to mix high yield with other income-oriented credit assets such as select emerging-market debt and US securitized assets.

But abandoning high-yield bonds would be a mistake. US high yield remains an attractive way to gain diversified exposure to the US economy, which continues to show signs of strength. And it has a track record of rebounding quickly from declines. It deserves a place in a well-diversified, income-oriented portfolio.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Article by Gershon Distenfeld, Alliance Bernstein