Falling 'Real' Yields Drive Investors to Junk Bonds

By Sebastian Pellejero

Investors are pointing to one key factor lurking beneath a recent rally in U.S. junk bonds: real yields.

Real yields are what investors earn from their bondholdings after compensating for inflation. After the Federal Reserve cut interest rates to near zero, accounting for inflation meant investors could expect to lose money holding U.S. Treasurys to maturity.

Analysts said falling real yields for U.S. investment-grade bonds are driving some investors in search of higher returns to the high-yield market. The real yield on a Bloomberg Barclays investment-grade corporate bond index has fallen to around 0.2%, according to data compiled from FactSet, from above 0.3% at the beginning of November.

"[Falling real yields] are pushing many investors out on the risk spectrum," said John McClain, portfolio manager at Diamond Hill Capital Management. "If you're buying investment-grade bonds out to 10-years, you're earning a potentially negative real yield."

Demand for speculative-grade bonds also has improved following the U.S. presidential election and signs of progress toward a vaccine for Covid-19. Those have been a boon to economically sensitive companies including American Airlines Group Inc. and Occidental Petroleum Corp., seen as likely to benefit from a post-pandemic economic recovery.

This increased demand is helping bring down the extra compensation investors require to hold junk bonds to near pre-pandemic levels. Adjusted for options, the spread, or extra yield demanded to hold speculative-grade U.S. corporate bonds in the Bloomberg Barclays index over Treasury bonds, fell to 4.27 percentage points Monday, according to FactSet. That brings the index's spread down to around 0.2 percentage points from Nov. 9 close -- the lowest level since late February.

November's rally extended the junk-bond market's recovery. Fears this spring that the coronavirus crisis would spur bankruptcies and a prolonged recession drove many investors to dump lower-rated corporate bonds, sending bond prices down and yields up past 10% -- a level that indicates market stress.

Now, investors' move into companies poised to benefit from a resurgence of growth boosted the high-yield market broadly, because it includes many borrowers that operate in so-called value sectors, such as energy, financials, and industrials, among others.

"The [corporate] constituency that makes up high-yield is very pro-cyclical, so the market is seeing some benefits from the rotation into value," said Mr. McClain. Diamond Hill's high-yield fund has gained 7.35% this year as of Oct. 31, placing it in the first percentile of managers surveyed by Morningstar.

On Monday, after the latest round of encouraging results from vaccine trials, the extra yield investors demanded to hold investment-grade U.S. bonds in the Bloomberg index over Treasury bonds stood at 1.12 percentage points, the lowest level since late February.

Elsewhere in bond markets, U.S. Treasury yields were down Tuesday, on pace to break a two-day streak of gains. The declines followed Commerce Department data that showed retail sales in October increased less than expected, raising questions of a slowing economic recovery.

The yield on the benchmark 10-year Treasury note recently traded around 0.871%, according to Tradeweb, down from 0.906% at Monday's close.

Write to Sebastian Pellejero at [e-mail]

Corrections & Amplifications

This item was corrected at 3:30 p.m. ET to show that Diamond Hill Capital Management's high-yield fund has gained 7.35% this year as of Oct. 31, not Oct. 21.

(END) Dow Jones Newswires

11-17-20 1524ET