US high-yield bonds are a compelling alternative to US equities given their continued attractive yields of the asset class, according to analysis from London-based exchange-traded fund issuer Source.

Despite the fact that US high-yield bond spreads have gone above 7% for only the sixth time since 1986, Source believes that the US high-yield asset class still represents a strong opportunity for investors. The high-yield bond spread (the percentage difference between current yields on various classes of high-yield bonds compared to Treasury bonds or similar high quality corporate bonds) is a significant measure of the credit-worthiness of the lender.

Fabrizio Palmucci, Executive Director, Fixed Income Specialist at Source.

According to the issuer’s research, even if the default loss rate over the next five years were to match the worst five-year period on record, the annualised return on US high yield would still be above 4%.  An average default cycle over the next five years would result in a 6% return.

Fabrizio Palmucci, Executive Director, Fixed Income Specialist at Source, commented: “In our view, US high-yield is a compelling substitute for equities given the attractive yields, and also offers better downside protection. Interestingly, our analysis reveals that equities took twice as long as high-yield bonds to regain their losses after the financial crisis, and equities also took nearly seven years to regain the cumulative returns of high-yield.

“Although the volatility has been higher in the US lately, even with a yield of 10% the US market looks compelling to us from a risk-return perspective. The valuations are interesting and are currently pricing a 11% default rate. This is far from our base scenario which factors in a 5% default rate, itself higher than the 4.5% historical average.

“With global risk aversion and the global economic cycle, the US high-yield market offers value considering our base macro-scenario. It offers a good alternative to US equities especially as these are looking expensive. Given our view for a limited upside for US equities, US high-yield today offers attractive yields while limiting the downside (bond floor) versus equities.”

The global high-yield bond market is predominantly US-centric: as of the end of January 2016, US high-yield assets amounted to $1.3tn compared to €308bn for its European counterpart.

In terms of investment opportunities for ETF investors, Source offers the PIMCO Short-Term High Yield Corporate Bond Index Source UCITS ETF (STHY LN), linked to the performance of the BofA Merrill Lynch 0-5 Year US High Yield Constrained Index. The fund has more than $800m in assets under management.

This BofA Merrill Lynch index is comprised of US dollar-denominated below-investment-grade corporate debt securities publicly issued in the US domestic market with remaining maturities of less than 5 years. Constituents are capitalization-weighted, based on their current amount outstanding, provided the total allocation to an individual issuer does not exceed 2%. The fund follows a stratified sampling index replication approach and held 378 securities as of 31 January, 2016

The securities comprising the index have a below investment grade rating, based on an average of the ratings of Moody’s, Standard & Poor’s and Fitch. In addition, qualifying securities must have a minimum $100 million of outstanding face value and a fixed coupon schedule.

The ETF is listed on the LSE, SIX Swiss Exchange and Borsa Italiana, and is available in USD (TER 0.55%) and euro-, sterling-, and Swiss franc-hedged share classes (TERs 0.60%).