Keeping Quality With Junk Bonds

Investment-grade corporate bonds are rallying to start 2019, but concerns remain about a potential raft of downgrades for BBB-rated bonds.

Those bonds, which represent a major chunk of the U.S. corporate bond market, are rated one to three notches above junk territory and almost half of those bonds cling to a rating that is just one level above high-yield status.

What Happened

Concerns about the vulnerabilities of BBB-rated corporates were among the factors behind a 2018 decline of 3.8 percent for the Markit iBoxx USD Liquid Investment Grade Index, one of the most widely followed gauges of high-quality corporate debt. That benchmark allocates over half its weight to BBB-rated debt.

Broadly speaking, the U.S. corporate bond market faces some challenges this year, but some strategies can help investors remain engaged with corporate debt. That includes the WisdomTree Fundamental U.S. Short-Term High Yield Corporate Bond Fund SFHY.

SFHY, which is almost three years old, targets the WisdomTree Fundamental U.S. Short-term High Yield Corporate Bond Index. The benchmark “is a rule-based alternatively weighted index designed to capture the performance of selected issuers in the US high yield corporate bond market that are deemed to have attractive fundamental and income characteristics,” according to WisdomTree.

Why It's Important

In what could be a trying environment for junk bonds, SFHY has the potential to weather those storms while helping investors boost their portfolios' income profiles as the fund has a 30-day SEC yield of 6.16 percent.

SFHY's underlying index uses a screening process aimed at unearthing corporate bonds with attractive fundamentals and income traits.

“Our research found that filtering out private issuers and issuers whose free cash flow (FCF) is negative can provide exposure to a higher-quality portfolio with better risk-adjusted returns,” said WisdomTree in a recent note. “In addition, the index is overweight in issuers with a higher risk-adjusted spread to Treasuries as a tilt toward income needs. Impact: SFHY had a single default—4 basis points (bps) in market-value terms—in 2018 compared with roughly 30 defaults in the HY broad market.”

Nearly 91 percent of SFHY's components are rated BB or B and the fund's exposure to highly speculative CCC-rated bonds is just 4.4 percent. Conversely, the widely followed Markit iBoxx USD Liquid High Yield Index devotes almost 11 percent of its roster to CCC bonds.

What's Next

SFHY's efforts to dodge negative cash flow issuers while overweighting fundamentally sound junk bonds could pay off for investors this year.

“Cutting bonds with negative fundamentals and over-weighting attractive bonds with lower default probabilities drove a positive selection effect of 114 bps,” said WisdomTree.

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