Complement your core fixed income with high-yield corporate bonds and senior loans

Meet the challenge of rising rates with a more diversified approach
Market Insights: June 22, 2017

Summary

  1. The 35-year bull market for investment grade bonds has effectively come to an end. To help meet their objectives, investors should consider complementing their core investment grade holdings with other income-generating asset classes.

  2. Incorporating a combination of high-yield corporate bonds and senior loans offers the potential for enhanced risk-adjusted returns and increased diversification.

  3. An active approach is essential to selecting securities in this space to mitigate risk and capitalize on opportunities.

1. End of an era

Canadian investment grade fixed income has had a remarkable run over the last 35 years. The reason is straightforward enough: yields have charted a largely downward course. Take, for example, the Government of Canada 10-year bond. Its yield declined from 16.4% in June of 1982 – when the Bank of Canada was aggressively fighting inflation – to 1.48% in April of this year.

Figure 1: Government of Canada 10-year bond yield

Source: Bank of Canada, April 2017.

Falling yields have given investment grade bondholders meaningful price appreciation – an attractive complement to low default risk and reasonable income. But it appears that this generational opportunity has effectively come to an end.

With current low yields, investors are not getting the income they need from investment grade. In addition, portfolios could suffer if interest rates rise, especially given that longer-duration investment grade bonds are more susceptible to rising rates than in the past (table 1).

Table 1: Impact of yield increases on investment grade bond prices, 1997 versus 2017

Based on FTSE TMX Canada Universe Bond Index. Source: PC Bond, April 2017.

2. Adding high-yield bonds and senior loans

To reach their goals, investors may need to complement their investment grade bond holdings with other income-producing asset classes, such as high-yield corporate bonds and senior loans. Expanding the opportunity set in this way can generate enhanced risk-adjusted returns and provide diversification.

  1. Risk-adjusted returns
  2. Fixed-income investing involves a number of risks. Three of the most important are:

    • Interest rate risk – rising interest rates cause bond prices to decline
    • Credit risk – the risk that the issuer of a debt instrument defaults or becomes insolvent
    • Inflation risk – inflation can cause an erosion of purchasing power

     

    The table below illustrates how adding high-yield bonds and senior loans to core investment grade holdings can deliver a high degree of protection from all three risks. This can translate into potential for positive performance in virtually all market environments.

    Table 2: Relative yield and risk profiles of investment grade bonds, senior loans and high-yield bonds

    For illustrative purposes. Source: IA Clarington Investments.

    The graph below illustrates the yield advantage of high-yield bonds and senior loans over investment grade bonds.

    Figure 2: Fixed-income yield comparisons

    Source: PC Bond, Credit Suisse, April 30, 2017. Government bonds represented by the FTSE TMX Canada All Government Bond Index; bond universe represented by the FTSE TMX Canada Universe Bond Index; IG corporates (investment-grade corporate bonds) represented by the FTSE TMX Canada All Corporate Bond Index; senior loans represented by the Credit Suisse Leveraged Loan Index (USD); and high-yield bonds represented by the BofA Merrill Lynch High Yield Master II Index (USD).

    Historically, a fixed-income portfolio of 75% investment grade, 12.5% high-yield bonds and 12.5% senior loans has offered a highly attractive risk-adjusted return profile (figure 3).

    Figure 3: Combining core fixed income with high-yield bonds and senior loans

    Investment grade represented by the FTSE /TMX Canada Universe Bond Index; high-yield bonds represented by the BofA Merrill Lynch U.S. High Yield Master II Index USD; senior loans represented by the Credit Suisse Leveraged Loan Index USD. Source: Bloomberg (March 31, 2017) for the period April 30, 2002 - March 31, 2017.

    High-yield bonds offer a higher return profile than senior loans, but this comes with greater volatility (figure 4). High-yield bonds also have more potential for capital appreciation, as they tend to have more call protection.

    Figure 4: Average 5-year rolling risk/return

    Source: Zepher Style ADVISOR April 30, 2017. Rolling period range: February 1992 – April 2017. High-yield bonds represented by the BofA ML HY Master II Index USD; senior loans represented by Credit Suisse Leveraged Loan Index USD.

     

  3. Diversification benefits
  4. Adding both high-yield bonds and senior loans to an investment grade core has the potential to provide diversification to the fixed-income portion of investor portfolios. This stems mainly from differences in sector and issuer composition between the two.

    On the sector level, high-yield bonds have greater exposure to communications, energy and materials, while senior loans have greater exposure to consumer discretionary, healthcare and technology (figure 5).

    Figure 5: Sector breakdown for high-yield corporate bonds and senior loans

    Source: Bloomberg, March 2017. High-yield constituents represented by the BofA Merrill Lynch High Yield Master II Index (USD); senior loan constituents represented by the Credit Suisse Leveraged Loan Index (USD).

    Combining high-yield bonds and senior loans provides diversification of company exposure. At the issuer level, there are 882 companies in the high-yield space, while 1,189 companies make up the senior loan universe. Only 294 companies are common to both (figure 6).

    Figure 6: Issuer overlap in high-yield bonds and senior loans

    Source: Bloomberg March,2017. High-yield constituents represented by the BofA Merrill Lynch High Yield Master II Index (USD); senior loan constituents represented by the Credit Suisse Leveraged Loan Index (USD).

3. The need to be active

Potential for higher yields, increased diversification and protection from rising rates and inflation make high-yield bonds and senior loans a potentially sound choice for an investor’s fixed-income holdings. But because these instruments are more susceptible to credit risk, it is critical to gain exposure through a risk-conscious, active approach that includes:

  • An assessment of economic fundamentals that can affect a company’s ability to meet its financial obligations and avoid default
  • Deep analysis of company fundamentals and credit quality
  • The ability to identify valuation anomalies across sectors and companies

For actively managed solutions that provide diversified access to high-yield corporate bonds and senior loans, retail investors can look to IA Clarington Strategic Corporate Bond Fund and IA Clarington Floating Rate Income Fund or IA Clarington U.S. Dollar Floating Rate Income Fund.

For more information about iA Clarington mutual funds, please contact your iA Clarington sales representative.

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