2015 has been a year when few asset classes performed well and many did poorly. Commodities fell by almost 30% and emerging market stocks and bonds both suffered double-digit declines. But while the travails of these asset classes are nothing new—all three also lost ground in 2014—one asset class experienced a complete reversal of fortune. High yield bonds have lost more than 5% of their value this year, their first down year since the financial crisis in 2008. That arguably makes high yield bonds this year’s most disappointing asset class.
What’s caused high yield bonds so much pain recently? High yield’s strong performance over the previous 6 years is partly to blame. The strong performance for the asset class drove down the spread—the difference between the yield on high yield bonds and the yield on treasury bonds—to less than 3.5% by the middle of 2014. That’s far below the average spread of almost 6% during the past 15 years. The small spread meant there was less cushion if some companies that issue high yield bonds started to struggle, which is what happened when the prices of energy commodities collapsed.
The Federal Reserve’s decision to start raising interest rates also played a part. The low interest rates that have persisted since the financial crisis made it easier for companies to roll over their existing debt or raise more money to keep afloat. But as interest rates begin to rise, the number of companies that are forced to default on their debt could rise as well.
In recent weeks the collapse of some high yield bond funds added further fuel to the high yield fire. The most prominent was the Third Avenue Focused Credit Fund, which had to shut down following losses and a subsequent wave of redemption requests from its clients. This turmoil spooked investors and forced the fund to sell its holdings, both of which further pushed down high yield bond prices.
Whether high yield bonds can rebound from their disappointing year will depend on a few factors. The Fed isn’t likely to raise interest rates very far or very fast, but continued economic growth could prompt a handful of small interest rate hikes in 2016. The result would likely be a higher default rate for high yield bonds, although this could be partly tempered by the stronger economy. And if commodity prices don’t bounce back, the energy portion of the high yield market will continue to be hit especially hard.
The good news for investors is that because of high yield’s struggles in the past year, the spread over the yield on treasury bonds is up to almost 7%. The higher spread suggests that a sizable increase in defaults is already incorporated in bond prices. If the rise in defaults turns out to be less severe than expected, high yield’s 2015 performance will look like an anomaly rather than the start of a trend.