The recent strengthening of the U.S. economy, however, suggests that junk bonds face less default risk. Indeed, Fitch Ratings noted in August that high-yield defaults are on pace to be at their lowest level since 2007 and “could finish below 1% by year’s end.” VanEck’s Rodilosso says “high-yield bonds sport yields that are historically tight [in terms of the spread compared to blue-chip bonds] but many high-yield issuers are on very solid financial footing these days.”
Anders Persson, chief investment officer of global fixed income at Nuveen, says leveraged loans and preferred stocks will also continue to see improvement. “Corporate balance sheets are growing healthier, and ratings agencies are upgrading bond issues, not downgrading them,” he says. Persson thinks this is a good time to shoulder credit risk, favoring “lower quality over higher quality.” He suggests that the Nuveen Preferred Securities and Income Fund (NPSRX), which has more than 80% of its assets invested in the banking and insurance sectors, is ideally positioned to benefit from a firming economy and low bond default rates.
While investment strategists such as Persson suggest positioning fixed-income portfolios for a firming economy, high-yield bonds might move out of favor if signs emerge that the current expansion is starting to wane. Even if the underlying finances of high-yield issuers themselves remain strong, the mere perception that defaults could increase might push high-yield bond prices well lower.
Still, the current junk bond yield at around 4% seems tempting when blue-chip corporate bonds are yielding less than 2.5%. Bassuk at AXS thinks that looking at sub-investment-grade bonds within an environmental, social and governance framework can solve the risks associated with them.
“ESG ratings help identify bond issuers that adhere to good governance practices,” he says, adding that “well-run firms that make smart capital allocation decisions tamp down the risks associated with high yields.” His firm’s AXS Sustainable Income Fund (AXSKX) owns bonds issued by firms that grade well in the context of decarbonization, social responsibility, diversity and inclusion, and transparency and disclosure. The fund currently yields around 4.4%.
“Fallen angels” offer another way of tapping the impressive payouts of high-yield bonds. These bonds were once investment grade, but they were downgraded to junk status by the rating agencies for a variety of problems that might be temporary—perhaps because of a sizable acquisition that put the acquirer’s bonds under review. When that happens, funds that owned the bonds as investment-grade securities must sell the holdings, pushing the bonds down in price. Fallen angel funds benefit by buying these securities when they’re out of favor and unload them once the investment-grade ratings have been restored.
The VanEck Fallen Angel High Yield Bond ETF (ANGL) is the largest in this category, with $5 billion in assets and a 0.35% expense ratio. Morningstar says the five-star rated fund has led its average peer by an annualized 3.6 percentage points over the past nine years.
Kelly Ye at IndexIQ isn’t a big fan of high-yield bonds these days, however, noting that “investors are being forced to take on undue risk” for what are historically low spreads. She adds that investors are likely to continue to shun long-term bonds ahead of a possible rise in interest rates. In the current environment, she focuses more on senior loan funds, which offer decent yields without taking on excess duration risk. Senior loans typically offer higher yields than blue-chip bonds but lower yields than junk bonds, since bank loans are more senior in the capital stack and ranked above all unsecured loans that a firm carries on its books. The SPDR Blackstone Senior Loan ETF (SRLN) is the largest in the category and has a 30-day SEC yield just below 4%, and the average maturity of its bonds is 5.1 years.
Schenone says a rising rate environment can still be beneficial for equities. She also noted in a September blog post that convertible bonds offer some of the upside offered by equity markets and the downside protection of fixed income. The iShares Convertible Bond ETF (ICVT), with $1.7 billion in assets, “is generally less influenced by changes in interest rates than other fixed-income securities,” she says.
Municipal bonds also offer a stop on the carousel of fresh fixed-income ideas. Hornby notes that a potential hike in tax rates in coming months may push more investors toward these bonds—especially since finances at the state and local level are now far stronger than they have been in recent memory, thanks to federal stimulus efforts in 2020 and 2021.
Scratch beneath the surface and you’ll find a variety of fixed-income opportunities still available. While credit risk is not a current concern for many strategists, duration risk surely is, pushing long-term bond funds out of favor.
Yet an uncertain inflation and interest rate backdrop could eventually lead to more respectable payouts among long-term fixed issues. That’s why the playbook is bound to evolve as we head into 2022.