Investors seeking a somewhat more conservative cyclical exposure should consider tactically replacing some U.S. equity exposure with high-yield corporate bonds.
A fter the initial phase of the recovery, the relative performance of high-yield vs. equities has been range-bound, reflecting improving corporate balance sheet health, headwinds to growth and a “search for yield”.
Junk bonds outperformed equities during the two flight-to-quality bouts in 2010 and 2011. High-yield issues of course also declined in absolute return terms, but were generally less volatile and experienced relatively modest sell-offs. In total return terms, high-yield bonds fell only by one-third of the amount that equities did in the 2010 selloff episode, and declined 50% less than equities did in 2011.
While there has recently been some concern expressed in the financial press about the high level of gross issuance in the corporate bond universe, most (if not all) of this activity represents refinancing by firms. Refinancing alone should not put upward pressure on spreads. Net corporate bond issuance over the past year has essentially been flat according to Flow of Funds data, and while these results cannot be broken down by credit quality, it is unlikely that the story is materially different for high-yield than for investment-grade issuers.
Our base case view is that equities will outperform junk by a modest amount this year. Nonetheless, junk bonds stand to decline by less in the event that euro area contagion returns to global financial markets. The recent equity rally has presented investors with an opportunity to take partial profits and rotate into a less volatile, but still cyclically exposed asset class.