For many fixed income investors, there’s one question that comes to mind when venturing outside of the safety of Treasury bonds. And that’s, “How much more yield am I getting and does that yield compensate me enough for any additional risk?” Often these yield spreads over Treasury bonds can be used to determine value and expected total returns.
But there are some areas of the bond market where active management makes more of a difference than spreads.
This is the case with high yield and junk bonds. Active management is the real determining factor in what investors earn above and beyond Treasuries. And with that in mind, the key to gains in the sectors isn’t about extra yield, but about credit research.
Credit Spreads: A Primer
Both issuers and buyers of bonds tend to focus on one key metric: yield. More specifically, they tend to focus on the yield spread. This is the difference between the yield on a comparably issued Treasury bond of the same maturity and the underlying bond in question. The idea is that Treasuries—whether one month or 30 years—are considered the risk-free rate of return. After all, the Federal debt is considered as good as gold.
The yield spread tells investors how much more income they are receiving to take on the additional risk of buying something that isn’t a Treasury bond.
These spreads ebb and flow, contracting or expanding based on a wide range of factors. Looking at historical data, we can determine if a bond variety or sector is a good deal and potentially map out total returns. Tight spreads could indicate investors are paying too much for a security type and much of the return will come from that coupon. The opposite shows that price improvement can be added to the equation. Options and derivatives can be used to change the spread.
But basically, a credit spread is the extra income earned over a comparable bond.
Junk Bonds & Spreads
Given the definition of credit spreads, you’d think that investors in the riskiest segments of the bond market weren’t being adequately compensated for the additional risk. Today, junk bond spreads are pretty low. In fact, according to S&P, spreads on high-yield bonds are right around their lowest point going back to nearly 2003.
Looking at all of 2024, the spread between five-year junk bonds and five-year Treasuries has fallen from 296 basis points (bps) to 234 bps. Rising yields on Treasury bonds due to uncertainty, along with the Federal Reserve cutting rates, have created a weird environment where spreads have continued to shrink.
On the surface, it appears that junk is a bad deal for investors. But digging deeper, that may not be the case. That’s because the spreads between junk bonds and Treasuries don’t tell a complete picture.
For one thing, tightening spreads is a good sign for junk and can be seen as a strength within the asset class. Narrowing spreads means that economic news is good and recession risk is being removed. That’s positive for junk bond issuers as it means that repayment is more likely and default potential is diminished.
Secondly, narrowed spreads—due to economic growth—can be a long-term phenomenon. According to data from asset manager AllianceBernstein (AB), since the mid-90s, tight spreads have remained that way for more than two years, on average. This chart from AB highlights the spreads. As you can see it’s the shocks—such as the Dotcom Bust, Great Recession, and COVID-19—and the current interest rate change that move these spreads. 1
Source: AB
The other key piece of data from AB is that during these periods of tight spreads, junk has still managed to produce some very strong, equity-like, and bond market-beating returns. On average, that’s about 6.6%. Moreover, the vast bulk of the time, junk still managed to produce positive returns.
Active Management & Credit Analysis
So, spreads for junk bonds are naturally close and will perform slightly better on yield than Treasuries. With that in mind, the question for investors is how do they generate additional outperformance. The answer is in active management and credit research.
According to AB’s research—and backed up by other asset managers—active management is how to win during these tight-spread environments. That’s because high-yield bonds are a tough nut to crack. Many junk bonds trade on over-the-counter (OTC) exchanges where liquidity is an issue. Meanwhile, the junk markets tend to comprise smaller firms whose information isn’t as easy to obtain.
However, active managers can conduct credit and cash flow research into the underlying firms. This allows them to avoid pitfalls and defaults before they happen. Moreover, they can buy bonds at discounts to their value or at slightly greater spreads than average to provide a larger safety and, perhaps, increased yields.
All of this works together for active managers to outperform the broader high yield indexes. All in all, over 75% of the lowest-cost active managers in the junk bond space have managed to beat the indexes over the last decade and active managers tend to beat those benchmarks by 0.7% per year. This may not seem like a lot, but in the bond sector that type of outperformance is quite good.
Avoiding defaults and blowups is the key.
The surge in the number of active ETFs covering the junk bond space is only an improvement on these trends. Active ETFs with their lower costs, zero cash drag, and ability to reduce taxes only enhance the ability of active managers to make the most during these low-spread environments. That’s just what investors need.
Active Junk Bond ETFs
These funds are selected based on their ability to access high-yield bonds with an active touch. They are sorted by their one-year total return, which ranges from 7.4% to 10%. Their expense ratio ranges from 0.22% to 1.02%, while they have AUMs between $175M and $7.7B. They are currently yielding between 6.2% and 9.6%.
| Ticker | Name | AUM | 1-year Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| YLD | Principal Active High Yield ETF | $258M | 10% | 7.7% | 0.39% | ETF | Yes |
| PHYL | PGIM Active High Yield Bond ETF | $192M | 9.8% | 9.6% | 0.39% | ETF | Yes |
| FLHY | Franklin Highx Yield Corporate ETF | $601M | 9.6% | 7.3% | 0.40% | ETF | Yes |
| HYBL | SPDR Blackstone High Income ETF | $230M | 9.6% | 7.5% | 0.70% | ETF | Yes |
| THYF | T. Rowe Price U.S. High Yield ETF | $463M | 9.3% | 7.1% | 0.56% | ETF | Yes |
| BKHY | BNY Mellon High Yield Beta ETF | $347M | 9.3% | 8.3% | 0.22% | ETF | Yes |
| SRLN | SPDR Blackstone Senior Loan ETF | $7.67B | 8.9% | 7.6% | 0.70% | ETF | Yes |
| HYFI | AB High Yield ETF | $175M | 8.8% | 6.7% | 0.40% | ETF | Yes |
| FTSL | First Trust Senior Loan Fund | $2.21B | 8.7% | 6.9% | 0.87% | ETF | Yes |
| HYLS | First Trust Tactical High Yield ETF | $1.64B | 7.4% | 6.2% | 1.02% | ETF | Yes |
Unlike many other areas of the fixed income market where spreads can be used to determine real valuations or potential returns, spreads may be less useful when it comes to high-yield bonds. Tight spreads are a good sign and the trick is more about credit than simply focusing on the extra yield earned. With that in mind, active management and active ETFs could be the way to go in the junk space.
The Bottom Line
On the surface, credit spreads in the world of junk bonds may indicate some poor results. However outperformance can be had if investors focus on credit research. Active management and active ETFs are the way to fight these periods of tight credit spreads and beat the broader bond indexes.
1 AllianceBernstein (September 2024). High-Yield Opportunity Persists, Despite Tight Spreads
