Strong start
High yield bond and senior secured loan prices ticked higher this week against the backdrop of record-high U.S. stock prices, solid corporate earnings and rising U.S. Treasury rates.1 Despite higher new issuance volume and the second consecutive weekly outflow, high yield bonds were modestly higher this week as investors continue to show a willingness to reach down the credit ratings spectrum in search for yield.2 Year to date, high yield bonds are providing returns of 1.35%, continuing to build on the 17.5% in gains achieved in 2016, with CCC rated bonds and energy high yield bonds among the best performers.2,3,4 High yield bond mutual funds recorded outflows of $1.4 billion during the two weeks ended January 25, erasing a portion of the $8.6 billion in net inflows observed over the prior eight weeks.5 Bank loan mutual funds, on the other hand, posted another $1 billion in inflows as investors continued to show a preference for investments whose values have historically been less affected by rising interest rates.5 Year to date, senior secured loans are providing returns of 0.55% with energy and CCC rated senior secured loans each outperforming the broader benchmark index by a wide margin.6,7,8

Treasury crosscurrents
U.S. government bonds swung between losses and gains throughout the week, highlighting the bond market’s current sensitivity to President Trump’s policy prescriptions on trade and fiscal stimulus.9 While the prospect of large fiscal spending and lower taxes is likely to boost growth, a more protectionist stance has the potential to hurt U.S. exports and raise the prices of imported goods. U.S. Treasuries were caught in the crosscurrents, rallying at the start of the week only to sell off the following day as Trump and congressional leaders drew attention to the possibility of increased infrastructure spending.10 Despite this added volatility, U.S. Treasury yields rose for a second consecutive week, a sign that investors remain focused on the more pro-growth aspects of Trump’s agenda.

Growth constraints
While Trump’s first full week in office dominated the headlines, the Commerce Department’s advance estimate of fourth quarter GDP was the highlight of the economic calendar. The U.S. economy grew at an annualized pace of 1.9% in the fourth quarter, against expectations of 2.2%.11 Although consumer spending remained solid and business investment improved, net exports were a significant drag on activity.11 While the fourth quarter marks the eleventh consecutive quarter of positive GDP growth, it was a slowdown from the third quarter’s 3.5% growth rate and underscores the difficulty in boosting the economy’s growth rate.11 In a speech delivered last week, U.S. Federal Reserve Chair Yellen pointed to several broad trends that are likely to constrain economic growth, including slow labor force and productivity growth. Said Yellen, “Although I am cautiously optimistic that some of these forces will abate over time, I anticipate that they will continue to restrain overall growth over the medium term.”12

Chart of the week: Loans offer relative value

Senior secured loans offer similar yields to high yield bonds 2 Source: J.P Morgan. Yield differential (%) Historical average (79 bps) January 2010 January 2017 -0.5 0.0 0.5 1.0 1.5 2.0 3.0 2.5

  • With a total return of more than 17%, high yield bonds generated one the highest returns among major asset classes in 2016.13 The rally has continued into 2017 as the asset class has returned approximately 1.3% year to date.14
  • Following such a sustained strong performance, high yield bonds’ yield advantage over senior secured loans, which has averaged 79 basis points since January 2010, has since declined to approximately 13 basis points.15 This is from a peak yield differential of nearly 300 basis points in late January 2016.15
  • Traditionally, high yield bonds have offered investors a yield advantage over senior secured loans due to the varying risk profiles of the two asset classes.
  • Specifically, senior secured loans are senior within the capital structure, meaning that investors in these loans are generally first to be repaid in the event of a corporate restructuring. Further, senior secured loans are generally secured by an issuer’s assets, or collateral, and may offer a coupon that floats with interest rate movements.
  • High yield bonds feature fixed rate coupons and are often unsecured and subordinated in the capital structure.

1 Federal Reserve Bank of St. Louis,
2 Bank of America Merrill Lynch U.S. High Yield Master II Index.
3 Bank of America Merrill Lynch U.S. High Yield CCC and Lower Index.
4 Bank of America Merrill Lynch U.S. High Yield Energy Index.
5 Thomson Reuters Lipper.
6 Credit Suisse Leveraged Loan Index.
7 Credit Suisse Leverage Loan Index (Energy Component).
8 Credit Suisse Leverage Loan Index (CCC Component).
9 Federal Reserve Bank of St. Louis,
10 The New York Times,
11 U.S. Department of Commerce,
12 U.S. Federal Reserve,
13 High yield bonds are represented by the Bank of America Merrill Lynch U.S. High Yield Index relative to the S&P 500 Index, Russell 2000 Index and Bank of America Merrill Lynch U.S. Investment Grade Index.
14 Bank of America Merrill Lynch U.S. High Yield Index.
15 Based on the yield for the J.P. Morgan High Yield Bond Index less the J.P. Morgan Leveraged Loan Index.

The Alternative Thinking Week in Review market commentary and any accompanying data (“Market Commentary”) is for informational purposes only and shall not be considered an investment recommendation or promotion of FS Investments or any FS Investments fund. The Market Commentary is subject to change at any time based on market or other conditions, and FS Investments and FS Investment Solutions, LLC disclaim any responsibility to update such Market Commentary. The Market Commentary should not be relied on as investment advice, and because investment decisions for the FS Investments funds are based on numerous factors, may not be relied on as an indication of the investment intent of any FS Investments fund. None of FS Investments, its funds, FS Investment Solutions, LLC or their respective affiliates can be held responsible for any direct or incidental loss incurred as a result of any reliance on the Market Commentary or other opinions expressed therein. Any discussion of past performance should not be used as an indicator of future results.