Diving for Treasure in US High Yield Requires Skill

Bonds in the US high-yield market are as varied as the creatures in the sea. Invest carelessly, and you may get stung. But with careful analysis, investors can uncover gems at any stage of the credit cycle.

We strongly believe that high yield belongs in a diversified portfolio. But tracking a broad benchmark isn’t the best way to get exposure. Passive strategies ensure that investors end up owning every security and sector in the index—the good, the bad and everything in between.

That’s risky, because a market downturn or sudden shock tends to hurt the lowest-quality securities and most indebted sectors the most—think energy-sector companies between 2015 and 2016 and telecoms from 2000 to 2002. And the companies that have issued the most debt become the biggest weights in a high-yield index.

Active managers have the flexibility to seek out value and limit risk. That’s something investors should always want. But it’s especially important today. High-yield bonds, like equities and other risk assets, look somewhat expensive, and the issuers with the weakest balance sheets may struggle in a higher-interest-rate environment.

A DEEP DIVE TO FIND VALUE

Even so, there are still plenty of opportunities to be had. You just have to know where to throw your line. That starts with a broad sector-by-sector approach to the market, followed by a deeper dive into individual securities.

Some sectors today have the wind at their backs, while others look less attractive from a credit or valuation perspective. The following areas look attractive today:

HOMEBUILDERS stand to benefit from continued improvement in the US housing market, and several companies in the sector may even see their credit ratings rise into investment-grade territory in the years ahead.

BANKING fundamentals are strong, and large diversified banks are continuing to bolster their balance sheets.