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High-Yield Bonds Poised to Outperform in 2015

With falling interest rates behind us, we expect the high-yield market will outperform the investment-grade market, even if we see some energy-sector defaults.

This video transcript has been corrected to reflect the current long-term Treasury rates. The yield on the 10-year and 30-year bonds are currently around 2% and 2.6%, respectively. 

Dave Sekera:  Investment-grade corporate bonds performed strongly in 2014.  The Morningstar Corporate Bond Index, which is our proxy for the investment-grade corporate bond market in general, rose 7.2% last year.  Much of this outperformance was due to the decline in long-term interest rates.  So, for example, the 10-year Treasury bond declined by 86 basis points and the 30-year Treasury bond declined by over 120 basis points.  Currently, the 10-year is at about 2% and the 30-year is at about 2.6%.  Offsetting some of the benefit of lower interest rates, corporate credit spreads did widen in 2014.  For example, in the investment-grade sector, within our index, credit spreads widened about 20 basis points and ended the year at 140 basis points over Treasuries. 

With their lower duration and their higher sensitivity to corporate credit spreads, the high-yield market actually lagged the investment-grade market in returns last year.  So, for example, the Bank of America Merrill Lynch High Yield Master Index only rose 2.5%.  Credit spreads within the high-yield sector widened about 100 basis points over the course of the year and ended the year at 500 basis points over Treasuries.  Much of this widening occurred within the fourth quarter. As oil prices declined, [energy-sector] bonds just were decimated.  So, for example, that sector widened out 386 basis points over the course of the year--much of that coming within the fourth quarter.  To put that in context, the average bond price within the energy sector fell about 16 points over the course of the year, such that the average price within the energy sector for those high-yield bonds ended the year at 88 cents on the dollar. 

In our view, the declining interest rates, which have been a tailwind for investment-grade corporate bonds in 2014 and provided the excess returns, have probably run their course and we don't expect to see that again this year.  We do expect that the high-yield sector, though, will outperform the investment-grade corporate bond market.  So, for example, we're looking at 2% to 2.5% GDP growth this year; so even though we may see some increase in defaults in the energy sector, we expect the overall default rate for high yield to stay in the low single digits.  As such, with its lower duration, higher yield, and greater carry, we expect the high-yield bond market will outperform the investment-grade corporate bond market.