Where to Search for Yield Today

Russ explains why the quest for yield will remain challenging and why it may be time to give high yield bonds another look.

It’s hard to miss that there has been a pronounced slowdown in the U.S. economy this year. While I expect U.S. economic growth to re-accelerate in the second quarter and the Federal Reserve (Fed) to hike interest rates this fall, long-term rates are likely to remain muted.

In other words, as I write in my new weekly commentary, the quest for yield will remain challenging, reinforcing the case for considering high yield within a fixed income portfolio.

Part of the recent soft U.S. growth is admittedly a function of two temporary factors: a brutally cold winter and the West Coast port strike. That said, it’s worth reiterating how much economic numbers have disappointed of late. U.S. economic surprises continue to run at the most negative level since 2009, recent manufacturing reports have come in weak and March’s payroll gains were 126,000, below even the most pessimistic expectations. Although I continue to believe the underlying fundamentals of the labor market remain strong, first quarter gross domestic product is likely to disappoint.

Against this backdrop, it shouldn’t be surprising that bond yields remain low. This downward trend has been exacerbated by foreign central bank bond buying and a dearth of new supply.

But low U.S. yields are also a function of even lower yields outside the United States. Currently, 25% of the European sovereign bond market is trading with a negative yield. In France, government bonds of up to three years carry a negative yield. In Germany, it is eight years, and in Switzerland, 10 years. In this context, a U.S. 10-year bond offering a roughly 2% yield and, backed by a strong currency, actually seems appealing.

If Fed liftoff does occur this fall as I expect, it’s most likely to manifest in what is referred to as a flattening of the yield curve. In other words, we are likely to see a greater lift in shorter-term interest rates, with a less substantial rise in long-term rates.

So what does this mean for investors? With rates stuck near historic lows, investors are left searching for income wherever they can find it. High yield is one segment of the bond market they could consider. In recent weeks, the spread (or difference) between the yield of the 10-year Treasury and a high yield bond of comparable maturity actually widened a bit, roughly 0.45%, restoring some value in the space.

The bottom line: In an environment of generally decent (albeit recently disappointing) growth and gently rising yields, high yield offers attractive potential in a yield-starved world.

Source: Bloomberg.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog and you can find more of his posts here.

This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.  Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

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