Capital Ideas^™ 
Investment insights from Capital Group

Despite the Federal Reserve’s tightening of monetary policy, yields across most segments of the bond market remain relatively low. In response, many investors have allocated substantial portions of their fixed income portfolios to riskier segments of the debt market that offer greater income potential.

U.S. corporate high yield has been a primary destination for investor capital. These flows have helped fuel a rally throughout much of the last two years.

The Bloomberg Barclays U.S Corporate High Yield Index has seen spreads to Treasuries tighten by more than 300 basis points since early 2016. Following that tightening and after sustained price gains, high-yield valuations appear quite stretched.

High yield: Looming downside risk?

With the yield differential between the benchmark Bloomberg Barclays U.S. Corporate High Yield Index and relevant Treasuries hovering around 350 basis points in mid-December, risk premiums have been close to a 12-year low.

Likewise, the majority of high-yield corporate bonds are trading at a premium to par, providing minimal price appreciation opportunities for investors.

The narrower yield compensation means that in the current market environment, high-yield investors are being forced to take more credit risk to maintain similar levels of income offered by the asset class several years ago. Additionally, the high correlation between corporate high yield and equities amplifies the risk of negative returns during periods of market volatility relative to other fixed income asset classes.

Current yield levels and valuations do not appear to adequately reflect these risks. With many investors reliant on high-yield corporates for income generation, the downside risk to bond prices cannot be ignored.

Emerging markets debt: Improved fundamentals, favorable yields

Against the backdrop of broad-based global growth, fundamentals throughout many emerging economies appear well-supported. Debt levels in many of these countries are substantially lower than in the largest developed markets, often with economic growth that is outpacing much of the developed world.

Over the past two decades, the evolving depth and breadth of emerging markets has led to substantial improvements in the liquidity of the asset class. Many developing economies have corrected or improved debt imbalances that led to vulnerabilities during past global sell-offs. They have likewise benefited from a growing and more stable domestic investor base, meaningful extension of their yield curves and greater central bank autonomy.

Importantly for income-seeking investors, as fundamentals in emerging markets have shown steady improvement, yields have remained attractive. In fact, the average yield for Morningstar’s Emerging Markets Bond category, stood at 5.8% at the end of September with a 49% concentration of investment-grade bonds. This yield is 50 basis points higher than the Morningstar High Yield Bond category average and is achieved with substantially more investment-grade bonds, meaning that investors are taking comparatively less credit risk for more income potential.

Additionally, the idiosyncratic nature of developing economies and their currencies can help to provide some potential diversification benefits.

Conclusion

Modest growth and inflation trends suggest interest rates across many developed markets could remain lower for longer. Against this backdrop, income generation will continue to pose a significant challenge for investors. The need for yield must be balanced with considerations of risk and diversification.

Undoubtedly, emerging markets debt can be a higher risk asset class. Bouts of volatility are possible during market sell-offs, and currency exposure can also have a meaningful impact on returns.

That said, from an asset allocation perspective, emerging markets debt is a compelling option. Compared to U.S. corporate high yield, strategies such as American Funds Emerging Markets Bond Fund® can offer investors a favorable balance of income and volatility, alongside decent equity diversification potential.