Fixed income has faced a range of challenges this year, but in volatile, changing markets there have been several opportunities that have appeared, including within high yield. That’s what Kevin Flanagan, head of fixed income strategy at WisdomTree, tackled on his latest Basis Points podcast this week.
“Heading into 2022, a definitive argument could have been made that high yield fixed income was on the expensive side and spread levels finished last year at a pretty narrow plus 300 basis points,” Flanagan said.
High yield spreads have grown remarkably this year, hitting as high as +600 basis points in July, and did a complete reversal in 2022, going from one of the worst performing classes to one of the best within fixed income. As of the beginning of July, high yield returns were around -14% but they have dropped by almost half to -7.7% as of August 24, while the Bloomberg Aggregate Bond Index has remained between -9 to -10% over the same period.
The income portion has improved dramatically as well, Flanagan explained, with the yield to worst (the lowest possible yield on a bond as long as the issuer doesn’t default) up by 340 basis points year-to-date at 7.6%. It’s nearly doubled the yield to worst from July of 2021 at 3.5%.
“What’s interesting is that the U.S. high yield market has rallied in the wake of softer economic data which suggested the economy is in a technical recession,” Flanagan said. “This yield level places high yield in its more well-known, traditional role of an income provider in bond portfolios.”
Despite their recent outperformance, Flanagan is clear to point out that high yield spreads are still above their 4.0% average of the last seven and a half years.
“With recession and potential risk-off concerns remaining a prevalent part of the investment discussion, a high yield solution that recognizes this factor, it’s an important consideration for investors,” Flanagan explained.
Investing in High Yield with a Quality Screen
The WisdomTree U.S. High Yield Corporate Bond Fund (WFHY) offers exposure to select U.S. non-investment-grade corporate bonds (also known as “junk bonds”) but utilizes a quality screen and rules-based approach to identify companies that exhibit strong fundamentals and then tilts to more heavily weight those companies that have favorable income characteristics.
“We found that eliminating the public issuer universe with negative cash flow can serve as an important quality screen and helps to address the elevated credit risks apparent in the market-cap weighted approach and the goal being to mitigate credit concerns i.e. default risk,” said Flanagan.
In regards to quality, the fund invests in bonds with grades between BBB and CCC but is currently primarily invested in BB (49.55% weight) and B-rated (34.14% weight) bonds.
WFHY invests broadly across sectors, with allocations in media (13.59%), energy (11.07%), healthcare (10.58%), industrials (9.72%), and many other sectors as of August 23, 2022.
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