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High Yield Still Poised to Outperform

We continue to expect that high-yield bonds will provide better returns than investment-grade as underlying rates tick up and moderate economic growth holds down defaults.

Dave Sekera: In April, most fixed-income asset classes gave back some of the gains they generated earlier this year as underlying interest rates have risen. The Morningstar Core Bond Index, our broadest measure of the fixed-income universe, declined 38 basis points last month and is now only up a little under 1% thus far this year. The Morningstar Corporate Bond Index, which is our proxy for the investment-grade sector, lost 0.5% last month and is now only up about 1%, year to date.

However, in the high-yield sector, the BofA Merrill Lynch US High Yield Index rose 1.2% in April and has gained 3.8% thus far this year. The gain was driven by tightening credit spreads as the average credit spread of the index itself tightened about 56 basis points to 448 basis points over Treasuries. A significant portion of the tightening has occurred in the energy sector as oil prices recovered from their lows earlier this year. The average spread in the energy sector tightened 130 basis points and currently stands at 623.

In the first-quarter outlook we published late last year, we made our case on why we expected the high-yield market to outperform investment-grade credit this year. We continue to expect that high-yield will still provide better returns than investment-grade as the high-yield segment has a much lower correlation to underlying interest rates than investment-grade corporate bonds and is more dependent on economic conditions.

So, even though first-quarter GDP was disappointingly low, Robert Johnson, our director of economic analysis, continues to expect moderate economic growth in the U.S. this year. He is expecting 2.0% to 2.5% for the full year. This level of growth should be enough to hold down default rates, which, in turn, will support the high-yield market.

In addition, over the near term, we expect corporate bonds will continue to outperform Treasury bonds. As the ECB is only two months into its 18-month asset-purchase program, and as it buys sovereign and structured-finance bonds in the eurozone, those proceeds will most likely be reinvested in the corporate-bond market. This technical demand should keep credit spreads from widening and may provide the impetus for credit spreads to tighten further.