This is an extract from an earlier article at Systematic Income Premium
The situation facing income investors today is fairly unusual in the sense that corporate credit yields (as well as credit spreads) are at fairly elevated levels, while the overall macro and corporate fundamentals are reasonably strong.
Why do corporate bond yields look attractive now?
First, we have already seen a significant move in both Treasury yields as well as credit spreads. This means that high-yield corporate bond yields are at high levels relative to history, as the following chart shows. They have only been higher in the last decade during exceptionally challenging times, which, needless to say, were much more challenging than today.
Two, it is fairly unusual to see a move higher in Treasury Yields and corporate credit spreads at the same time. The two tend to move in opposite directions in “normal” markets, as the following chart shows. This means that when credit spreads are rising Treasury yields are “subtracting” from the overall corporate bond yield and vice-versa. This time around, both have pushed corporate bond yields higher at the same time. Obviously this is not coincidental – it is due to the Fed’s aggressive hiking trajectory as well as the potential for a hard landing, but it is still notable.
Three, one way to think about the currently high level of current credit yields is that it’s easier to be less wrong. For instance, with an underlying high-yield corporate bond yield of roughly 8% and a duration of roughly 4, that means that yields can move higher by 2% each year and a High-Yield corporate bond fund will be flat, i.e., with a roughly zero total return over the year (we are ignoring defaults in this exercise). In other words, the 8% carry will roughly offset the 4 x 2% mark-to-market loss in case yields rise further by 2%.
When yields were at 4% in 2021, you could only be wrong by 1% a year, i.e., if yields moved more than 1% year-on-year, the high-yield corporate bond fund would lose money overall on an annual basis.
What this means is that if we do see corporate bond yields rise further in the coming months, it will be much less painful than it would have been at the start of the year because of the additional 4% yield cushion. Another way to look at it is that investors are getting a 1% margin-of-safety rise in yields on an annual basis.
For investors who are happy to take a more aggressive stance, we continue to prefer the Credit Suisse Asset Management Income Fund (CIK), trading at a 5.9% discount and 9.44% current yield. The fund has been one of the strongest performers in the sector.
We would also watch the Allspring Income Opportunities Fund (EAD), trading at a 5.9% discount and 9.83% current yield. The fund will be cutting its distribution over the coming months because of its programmatic managed distribution policy. This will likely push its discount to even more attractive levels creating a better entry point.
Thanks for reading.
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