BLACKROCK INVESTMENT INSTITUTE

Seeking income in high yield bonds

Key points

  1. We see high yield bonds as a key source of income in bond portfolios, and advocate a balanced and diversified approach
  2. US-China trade tensions ratcheted higher, reawakening market focus on global trade risks. Crude oil prices rallied on supply concerns.
  3. Eurozone data this week may show stabilising growth. We expect a strong showing from populist parties in European parliamentary elections.

Seeking income in high
yield bonds

Global high yield bonds sold off amid the latest spike in market volatility, along with other risk assets. Yet this does not change our view that exposure to the asset class is important for fixed income investors in an environment where carry, or coupon income, is becoming the main driver of bond returns.

Chart of the week

Global high yield bond spreads, 2017-2019

Chart of the week

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index.
Sources: BlackRock Investment Institute, with data from Bloomberg Barclays, May 2019. Notes: The spread is the difference between the yield of a certain index and that of corresponding comparable-duration government bonds. The indexes used are the Bloomberg Barclays Global High Yield, Asia High Yield, US Corporate High Yield and Pan-European Corporate High Yield indexes.

The recent selloff in global high yield is evident in the small upticks in the far right of the chart above. High yield bond spreads – the difference in yields between high yield bonds and comparative government bonds – have widened, as perceived safe havens outperformed. These moves come amid a longer-term widening trend in credit spreads over the past couple of years. We see rates generally stable in the near term, with income taking back the reins from price changes as the key driver of credit returns in the quarters ahead, as we write in our latest Fixed income strategy update Carry is king. The patient stance of global monetary policy makers amid ongoing low inflation supports this view. A slowing, but still growing global economy – with recent data pointing to signs of European and Chinese growth pickups – does too.

How the regions stack up

A flare-up in US-China trade tensions sparked recent market volatility – and the accompanying selloff in high yield bonds and other risk assets. We see a narrow path ahead for risk assets to move higher at this late stage of the business cycle, but escalating trade conflicts could make this path even narrower (see our geopolitical risk dashboard for more on trade tensions). We believe a balanced, diversified approach is key to investing in this environment. For fixed income investors in particular, we see high yield bonds as a key part of this approach, given their income-providing potential.

We see reasons to like US high yield. First-quarter corporate earnings results pointed to healthier fundamentals in high yield issuers. These include signs of declining gross leverage and near-record high levels of interest coverage – a measure of issuers’ ability to service their debt. In addition, the longer-term credit quality of the index has improved. Evidence includes a shift in issuance toward higher quality (less CCC-rated bonds), shorter maturities and larger individual issues. Fewer leveraged buyouts and an increase in the share of secured bonds are also positives. We believe this improved risk profile should support greater stability in the asset class’s performance. We are more cautious on European high yield. Europe’s relatively greater vulnerabilities to geopolitical risks and slower growth make for a less attractive risk/reward profile, in our view. Yet we see the asset class as attractive from a fixed income portfolio perspective, particularly for US dollar based investors. Spreads on euro high yield bonds are roughly 1 percentage point higher than their US counterparts after adjusting for different ratings quality, we estimate. And interest rate differentials mean US investors can gain an extra 3 percentage points in yield after hedging euro exposure back into dollars.

Lastly, we see attractive income potential in Asia high yield, despite the risk of a further deterioration in the US-China trade relationship. Corporate fundamentals have improved since 2017 due to strong earnings, following years of deterioration. Bottom line: We see high yield bonds as an attractive source of income in a world where carry is king. And we advocate a balanced approach, given geopolitical risks such as global trade tensions — and potential for further late-cycle bouts of volatility.

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  • President Trump signed an executive order banning US telecoms firms from installing foreign-made equipment that poses a threat to national security. The US also added a key Chinese telecom firm to its “entity list,” potentially barring US companies from dealing with it. The White House delayed a decision on whether to impose tariffs on imported cars and parts to allow for more time for trade talks with the EU and Japan. And reports pointed to a lifting of US steel and aluminum tariffs on Mexico and Canada.
  • Crude oil prices rallied on supply squeeze concerns ahead of OPEC discussions over the weekend, and energy stocks outperformed. Saudi Arabia said drones attacked its oil facilities and warned the attacks undermined efforts to resolve Gulf tensions.
  • Economic data last week were mostly disappointing. April economic activity data in China surprised to the downside across indicators, while April US retail sales and industrial production came in lower than expected. First quarter gross domestic product (GDP) data for the eurozone and Germany were broadly in line with expectations and suggest a bottoming out of growth in Europe.

 


 

  Date: Event
May 20 Japan GDP
May 22 FOMC minutes
May 23 US, eurozone and Japan Purchasing Managers’ Index (PMI) reports; Germany Ifo; India general election results
May 23-26 European parliamentary elections

Our attention this week is on the global growth picture. European business surveys will be crucial to watch this week, with the preliminary PMIs providing the first reading of economic activity in May. We expect European growth to stabilise and pick up in the second quarter, as Chinese economic activity finds firmer footing and as our nowcast of eurozone growth is showing signs of bottoming out. Also in focus this week: the European parliamentary elections. We expect a strong showing from populist parties, which may negatively impact the pan-European initiative (read more on the European fragmentation risk).

Managing Director, is Global Chief Investment Strategist for BlackRock
Richard Turnill is Global Chief Investment Strategist for BlackRock. He was previously Chief Investment Strategist for BlackRock’s Fixed Income and active ...

Key Contributors

Isabelle Mateos y Lago

Isabelle Mateos  y Lago

Chief  Multi-Asset Strategist

Kate Moore

Kate Moore

Chief Equity Strategist

Jeffrey Rosenberg

Jeffrey Rosenberg

Chief Fixed Income Strategist

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