Investors queued up for US high-yield bond funds as rate cut hopes grow

US high-yield bond funds enjoyed the biggest inflows of the year in May, driven by the allure of higher yields, potential for price appreciation amid anticipated Federal Reserve rate cuts, and diminishing corporate credit risks.

According to LSEG Lipper data, US high-yield bond funds attracted USD 5 billion in inflows in May, the highest since December. From January to May this year, the total inflows reached USD 6.1 billion, marking the highest in three years.

“Combined with the attractive outright yields available, compared to 5 and 10-year averages, we are seeing investor confidence that strong corporate profits, together with an easing Fed, should provide an environment for default expectations to decrease,” said Chris Romanelli, portfolio manager at Loomis Sayles.

He also added that the expectations for Fed rate cuts have helped to fuel demand for floating rate credit which has increasingly been utilized in high yield bond funds.

S&P Global Ratings expects the US trailing 12-month speculative-grade corporate default rate to fall to 4.5% by March 2025, from 4.9% in April 2024.

Last month, the iShares iBoxx USD High Yield Corporate Bond ETF HYG led the pack with approximately USD 1.99 billion in inflows. Meanwhile, the iShares Broad USD High Yield Corporate Bond ETF and SPDR Portfolio High Yield Bond ETF garnered USD 1.09 billion and USD 537 million in net inflows, respectively.

According to the ICE BofA Global high-yield bond index, US high-yield bonds still offer over 310 basis points premium over 10-year US Treasury notes, buoying investor enthusiasm in these riskier junk bonds, amid fading recession fears and improved economic conditions.

Analysts expect that lower interest rates, stemming from potential Fed rate cuts, would benefit high-yield bond issuers by enhancing liquidity and easing the cash flow constraints that have intensified due to the Federal Reserve’s previous rate hikes.

However, the narrowing of yield spreads for high-yield bonds has deterred some investors from placing their money in high-yield bonds.

Mark Durbiano, head of the domestic high-yield group at Federated Hermes, said the biggest challenge for the high-yield bond market moving forward is historically tight credit spreads.

“Because we believe credit spreads are relatively close to all-time tights and reflect a “perfect landing” in the economy and inflation, we are reducing the overall risk in our high-yield portfolios,” he said.

“Although spreads are historically tight, especially in the higher quality portions of the index, a 7-7.5% carry provides a fairly decent cushion for spread widening compared to what we were accustomed to during most of the quantitative easing era,” said Adam Abbas, portfolio manager at Harris Associates.

“This makes the asset class attractive for those seeking absolute value and total returns.”

(Reporting By Patturaja Murugaboopathy and Gaurav Dogra in Bengaluru; Editing by Josie Kao)