Today’s Economy: Interest Rates Up, Banks Down
Recession in the U.S. may be the base case of prominent economists and investment strategists alike, but investors remain cautiously optimistic.
On March 30, the U.S. Consumer Confidence Index rose to 104.2, up from 103.4 the month before. To add to this, the U.S. labor market, a bellwether of the health of the overall economy (and a recent thorn in the side of the Fed as it fights inflation) remains strong. U.S. nonfarm payroll employment increased by 311,000 jobs in February of 2023.
What’s remarkable about this display of fortitude by the U.S. economy is its backdrop. The Federal Reserve has reached what’s likely the later innings of a steep hiking cycle, and the U.S. banking system has experienced several subsequent duration-related failures as a result. For context, the Fed raised the target fed funds range to 4.75 - 5.00 percent on March 23, its ninth increase of the cycle.
The silver lining amidst mixed signals and uncertainty? Fixed income markets have arrived at greener pastures after a barren and bumpy journey. Income is back, with bonds offering higher yields to investors. Finally, utilizing bonds as a portfolio diversifier and stabilizer relative to equities feels sustainable again.
In few places are yields as compelling as the U.S. high yield bond market. As of March 30, the ICE (NYSE:ICE) BofA U.S. High Yield Index yielded 8.52 percent. Notably, this nearly matches the long-term total return of the S&P 500 Index of about 9 percent.
Yet, as always, with the prospect of higher returns comes higher risk. As more companies feel the pressure of tighter monetary policy and brace for potential recession, higher volatility is expected in the U.S. high yield market. Considering this possibility, yield-seeking investors may be wise to use a quality lens.
Quality is Key in the Quest for Yield
By most important measures – perhaps the most prominent being the U.S. high yield default rate – the average company issuing below-investment grade debt is relatively healthy. As of February 2023, the default rate hovered at just 1.6 percent, which is markedly below the long-run average default rate of 3.6 percent.
Higher interest rates translate to better potential go-forward returns for bond investors, but they simultaneously mean increased costs for borrowers. In fact, issuing debt is the most expensive it has been in over a decade.
Since the beginning of 2022, the average cost of capital for below-investment grade companies has risen by 420 basis points, as estimated by the yield of the ICE BofA U.S. High Yield Index. But the Fed’s rate hikes only tell part of this yield story. Widening credit spreads over corresponding treasuries accounted for nearly 180 basis points of the total increase in yields. Credit spreads have widened by 66 basis points in March 2023 alone.
Put simply, the market may already be pricing some of the additional credit risk issuers present into bond prices. Companies facing steeper rates to borrow new money or refinance existing debt could face liquidity issues that tend to flare during economic slowdowns. To be specific, past recessions have shown that companies with negative free cash flow are less likely to be able to service debt and have a higher probability of defaulting during recessions.
To mitigate this risk when building a portfolio of income-producing bonds, investors should look through a quality lens. Overweighting fundamentally sound companies, ones with strong balance sheets and robust cash flows, can reduce portfolio risk and improve risk-adjusted returns. For the traditional role that bonds play in a portfolio – one that has been recently reinstated with yields returning to more normal levels – the importance of quality can’t be overstated.
To employ a quality-focused, diversified approach, fixed income investors need not employ active bond managers, who tend to come with higher management fees. Investors also may not want to settle with traditional market cap-weighted bond index funds. They’re known for overweighting issuers with the most outstanding debt, and typically, that’s not how most fundamental investors build portfolios with a potential recession looming.
Between the two, a middle ground exists: a diversified, rule-based approach to bond index investing that screens out debt-bloated issuers while tilting toward those with positive free cash flow.
An Actionable Solution for U.S. High Yield Bonds
WisdomTree U.S. High Yield Corporate Bond Fund (WFHY) is an alternatively weighted ETF designed to capture the performance of certain issuers in the U.S. high yield bond market. The fund uses a rule-based approach to seek exposure to companies with strong fundamentals, offering relatively higher yields.
The fund starts with a broad non-investment-grade corporate universe. To be included in this universe, bonds must meet minimum size and years-to-maturity constraints and are only considered if issued by public companies with positive fundamental factors. For each broad sector, the fund then tilts toward the bonds with the best income characteristics.
To ensure proper diversification, no single issuer can represent more than two percent of holdings in the ETF. Moreover, the resulting portfolio of corporate bonds is spread across the industrial, financial, utility, consumer, and energy sectors.
WisdomTree U.S. High Yield Corporate Bond Fund's focus on quality and diversification has been effective at mitigating credit and default risk. Since inception in 2016, its rule-based approach has limited the cumulative portfolio default rate to just 2.0 percent of par value as of February 28, 2023. This is compared to a cumulative default rate of 13.8 percent over the same period for the equivalent market cap-weighted index, the Bloomberg Barclays (LON:BARC) U.S. Corporate High Yield Index.
For investors seeking income from the U.S. corporate high yield bond market, WisdomTree U.S. High Yield Corporate Bond Fund (WFHY) is an effective solution. This strategy is best used as a complement to, or substitute for, existing portfolio high yield exposures, especially in the face of uncertainty.
This content was originally published by our partners at ETF Central.