High Yield Bond Update-Future Gains Will Accrue Slowly

06/08/2017 2:55 am EST

Focus: STOCKS

Marvin Appel

President, Signalert Asset Management LLC

Future gains in high-yield bonds this year will likely be muted, and you should take any sell signal seriously, asserts Marvin Appel, MD, PhD. He’s President of Signalert Asset Management LLC.

High-yield bond funds are doing well this year, outperforming investment grade bonds by 1%-2% in total return so far.  For example, the iShares Corporate High Yield Bond ETF (HYG) is up 4.3%.  Its SEC yield is 4.8%.  These figures are roughly representative of many high yield bond mutual funds.

However, the chart suggests that high-yield bonds are about to lose their momentum.  HYG has turned down, a modest decline that has been confirmed by an MACD sell.  (Both are circled in the chart below.)  Neither of these developments represents a warning of an imminent correction but is consistent the notion that further gains this year in high yield bonds will come more slowly than has been the case through May.

chart

Valuation concerns are also consistent with expectations of slow gains for as long as our models remain on buy signals. 

The chart below of the yield on a widely used junk bond index shows that high yield bonds are paying their lowest yields since 2014.  Although the spread to Treasuries was lower from 2005-2007 than it is now, it is the absolute yield rather than the spread that puts money in your pockets. 

Yields can remain low for extended periods, but currently the downside risk is greater than upside potential.  We will continue to follow our high yield timing models, which all remain on buy signals.  However, the current stretched valuation of high yield bonds suggests that the next sell signal could usher in a significant correction.

Key points

--High yield bond valuations are stretched.
--Positive momentum has slowed, although our yield timing models remain on buy signals.
--Future gains this year will likely be muted, and you should take any sell signal seriously.

chart 1

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