June 22, 2017

Not-So-High Yield

Diversified high-yield bonds may look like an enticing, low-cost way to boost an investor’s income, as the two largest high-yield bond ETFs show 12-month yields of 5.13% (HYG) and 5.89% (JNK).1

However, the fundamentals behind the yields tell a less compelling story. An objective, top-down assessment suggests investors are likely to earn minimal, if any, real return in these vehicles:

Starting Yield – Defaults + Default Recoveries – Fees – Inflation = Net Real Return

  • Starting Yield: The BofA Merrill Lynch High Yield Master II Index trades at a 5.5% yield-to-worst2, which is the lowest potential yield that can be received on a bond before default.
  • Defaults: According to Fitch, the default rate over the past 12 months for high-yield fixed income assets is 3.9%.
  • Recoveries: The historical recovery on high yield defaults is between 30% and 40%. Moody’s reported a recovery rate of 31.3% for all of 2016.
  • Fees: We used the average fee of 0.45% for HYG and JNK.
  • Inflation: 1.7%2, which is a market-implied projected inflation rate over the next five years, which is derived from the nominal bond rate minus TIPS.

While there is a chance that investors will outperform a 0.7% real rate of return in diversified high yield, the base-rate fundamentals do not paint a rosy picture. Investors will need to hope for lower defaults or higher recoveries than history would suggest. Lower-than-expected inflation could improve the net return, but it could also lead to deflationary fears and widening credit spreads that could weigh on the space even worse. Instead of a diversified ETF, we suggest investors consider our Income Strategy, which is concentrated in unique names and invested primarily in equities.

1Source: Morningstar. iShares iBoxx $ High Yield Corporate Bond (HYG) and SPDR Bloomberg Barclays High Yield Bond ETF (JNK).
2Source: Bloomberg. As of 6/16/17

The views expressed in this report reflect those of Miller Value Partners portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

©2017 Miller Value Partners

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