ETF Trends
ETF Trends

The high yield bond market has been on a rollercoaster ride in the past year, leaving many investors uncertain about whether they should participate in a segment roiled by worries that plunging oil prices will trigger defaults in the energy sector.

Oil prices fell in the back half of 2014, hitting the high yield market as investors feared a wave of defaults from energy-related issuers who use extensive debt financing. Although oil prices recovered in the first half of 2015, the fall of oil has resumed, shifting the sands under the high yield markets’ feet once again.

But I believe the recent high yield sell-off is overdone, and it has created an opportunity for investors to add short duration high yield exposures to their portfolios. Here are three reasons why:

  1. One bad sector doesn’t necessarily spoil the entire asset class: Investors are worried about defaults in the energy space, but it’s important to remember that energy accounts for less than 12% of the Barclays US High Yield 350mm Cash Pay 0-5 Yr 2% Capped Index.1 Struggles in one sector shouldn’t prompt investors to abandon the entire asset class. The Federal Reserve may be preparing to raise interest rates, and the impetus behind the boost is a strengthening labor market that’s fueling domestic demand. A healthy, consumer-driven economic recovery is supportive of credit, creating an environment where issuers are less likely to default.
  2. Spreads indicate that short duration high yield bonds are attractively valued: Energy default fears have caused spreads on an index of short duration high yield bonds to widen beyond their recent averages, pushing down prices. But, tactically speaking, historical analysis of the past 20 years indicates that when short term government yields rise in a given month, short duration high yield spreads tighten by 3%.2 In a recent survey, economists forecast the US 2-Year Yield to be 1.09% by the end of the year,3 which is over 40 basis points higher than today’s yield.4 This historical analysis would point to short term high yield bond prices rising from current levels, as spreads revert to the mean.
  3. Short duration high yield fundamentals remain intact: Default rates are well below historical averages—even more so if you remove energy. At the end of July, Fitch calculated the trailing twelve month default rate for short duration to be 2.5%, or 2.3% if energy is excluded.5 These default rates are well below the historical 4.6% average, according to Moody’s.6 Additionally, the ratio of downgrades to upgrades by analysts of high yield credits stands at 1.10 at the end of July; this is significantly lower than the crisis days of 2008 when that ratio was near 10.7

These factors have created a favorable environment for short duration high yield funds like the SPDR® Barclays Short Term High Yield Bond ETF [SJNK]. SJNK has a 12% exposure to energy, which is lower than the broader index of high yield exposures and will help to limit its potential exposure to possible defaults. At the same time, SJNK has a 30% exposure to consumer-related industries, and this has been a consumer-led recovery.

Although investors are worried about high yield defaults spiking as a result of continued falling oil prices, I don’t believe it makes sense to throw the baby out with the bath water and avoid the entire high yield sector. Short duration high yield funds still have a role to play in investors’ portfolios as a tool to deploy ahead of a potential rising rate environment—especially in light of the recent market dislocations for risky assets.

1Barclays US High Yield 350mm Cash Pay 0-5 yr 2% Capped Index, Barclays, as of 8/18/2015
2SSGA, Barclays. Based on monthly change of the US Treasury 2 Year Yield and change in spread of the Barclays US High Yield Cash Pay 0-5 Yr 2% Capped Index OAS 7/31/1995 to 7/31/2015.
3Bloomberg, as of 8/13/2015
4Bloomberg. As of 8/18/2015, the US Treasury 2 Year Yield was 0.66%.
5Fitch, as of 8/13/2015
6Moody’s, as of 8/17/2015
7Moody’s, as of 7/31/2015

David Mazza is a Vice President of State Street Global Advisors and the Head of Research for SSGA’s ETF and mutual fund businesses.