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High-Yield Bonds Trail as Rates and Oil Drop

Declining rates have boosted investment-grade securities, but the energy sector's woes have held back high-yield bonds.

Dave Sekera: Based on the decline in underlying interest rates thus far this year, investment-grade bonds have performed pretty well. Year to date, the Morningstar Corporate Bond Index, which is our proxy for investment-grade corporate bonds, is up about 7%. However, with the yield on the underlying index only being about 3%, predominantly that return, or the excess return that we have gotten thus far this year, has been due to those declining interest rates.

So, for example, the yield on the 10-year Treasury bond has declined by 70 basis points, down to about 2.3% right now. Really, that's been driven by a lot of macro-investors' concerns that this slowdown that we are seeing in the emerging markets and in Europe has really caused, or could potentially cause, a slowdown in GDP growth here in the U.S. as well.

However, high-yield has not performed nearly as well as investment-grade thus far this year. So, the BofA Merrill Lynch High Yield Index, which we use to measure the high-yield market, has only gone up 3.3% thus far this year.

And really, there are two main reasons why we've seen that. First, the duration of the high-yield index is much shorter than the investment-grade market, and so therefore, it's less sensitive to the interest-rate movements underneath those bonds. And secondly, we've also seen credit-spread widening in high-yield really gap out much further and farther than what we've seen in the investment-grade markets thus far this year.

So, for example, the spread on the high-yield index has gone out by 80 basis points from where it started this year to currently at about 480 basis points. In the investment-grade market, on our index, the spread-widening has only been 13 basis points thus far this year, and it currently stands at 133 basis points.

A significant portion of the spread-widening in the energy sector really started earlier this summer when oil prices peaked and started to come down, and that really has gained steam over the past couple weeks as oil prices has really come under significant pressure. A lot of investors are really starting to get worried about the default risk in that sector, especially for those high-yield issuers, because their break-even cost to extract oil out of the ground is significantly higher than what we see for the majors in the investment-grade index. In fact, credit spreads over just the past couple weeks have widened out anywhere from 250 to over 300 basis points on some of those individual bonds.

However, while we've seen about a 4.5% decrease in the high-yield energy sector, we've actually seen, thus far this year, a 5.8% increase in those energy names in the investment-grade market, as investors really aren't that concerned about default risks in the investment-grade versus the high-yield.

Looking forward into 2015, we expect that the positive economic momentum that we've experienced over the past couple quarters will continue, and we expect GDP growth of 2% to 2.5% over the course of next year, which generally should be supportive for corporate credit spreads. So, even though we expect, generally, that corporate credit should be positive and would expect the index spreads to tighten overall going into next year, if oil does stay down at these kinds of prices--around $60 and $70 per barrel--we could see the pressure from the oil sector offset the positive momentum that we would otherwise see within the index.