As the Federal Reserve Prepares to Cut Interest Rates, New High Yield Funds Are Hitting the Market

As the Federal Reserve prepares to cut interest rates, investors seeking to maintain steady income levels may need to explore riskier parts of the bond market, specifically high-yield or "junk" bonds. These bonds, which offer higher yields in exchange for greater risk, could become more attractive in a low-rate environment. However, investors should be mindful of the risks associated with such investments, especially in a volatile market.

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Columbia Threadneedle is one investment firm that believes active management can play a key role in the high-yield bond market. On Thursday, the firm introduced two new high-yield exchange-traded funds (ETFs): the Columbia U.S. High Yield ETF (NJNK) and the Columbia Short Duration High Yield ETF (HYSD). These ETFs are designed to target different areas within the high-yield market and offer investors options for exposure based on their risk tolerance and investment goals.

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Marc Zeitoun, head of North America product and business intelligence at Columbia Threadneedle, emphasizes the importance of having exposure to high-yield bonds, particularly as the Federal Reserve is anticipated to lower interest rates. According to the CME FedWatch tool, traders are expecting a 25 basis point (0.25%) rate cut next week, with further cuts likely by the end of the year. Zeitoun highlights the fact that while market rates may fluctuate, investors who rely on income cannot afford to lose consistency in their returns. He believes this is where high-yield bonds come into play, as they provide a steady stream of income even in uncertain rate environments.

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The performance of high-yield debt has been strong in 2023, outpacing the broader bond market. For example, the iShares Broad USD High Yield Corporate Bond ETF (USHY), the largest high-yield index ETF, has delivered a 7.2% return year to date, compared to 4.9% for the iShares Core U.S. Aggregate Bond ETF (AGG), which tracks the overall bond market. While Columbia Threadneedle's newly launched funds come with slightly higher fees compared to USHY, their costs are in line with other high-yield ETFs available in the market.

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Corporate bond yields, especially those in the high-yield category, are typically set relative to a risk-free benchmark such as U.S. Treasury yields. The riskiest bonds, or junk bonds, offer the highest yields as compensation for the added risk of default. However, the spread, or difference between the risk-free rate and high-yield levels, fluctuates over time and across different bond issues. Currently, the spreads between Treasury yields and high-yield bonds are unusually narrow, indicating that the market is underestimating the risk of defaults.

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Dan DeYoung, one of the managers of the NJNK fund, points out that the market is implying a default rate of around 1%, which he and Columbia Threadneedle view as overly optimistic. He explains that spreads have been near rock-bottom levels over the past year, suggesting that the market has low expectations for defaults. However, DeYoung and his team anticipate a more realistic default rate closer to 3%. The NJNK ETF is a rules-based fund with an active management component that aims to avoid the riskiest parts of the high-yield market. According to DeYoung, the fund is designed to maximize exposure to the strongest high-yield opportunities, offering investors a solid income stream while also benefiting from declining interest rates.

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While Columbia Threadneedle’s high-yield ETFs are new to the market and lack track records, DeYoung also manages the Columbia High Yield Bond mutual fund (CHYZX), which holds a four-star rating from Morningstar. This could provide some reassurance to investors looking for performance history and confidence in management expertise.

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High-yield bonds tend to perform well when interest rates fall because bond prices typically rise as rates decrease. This is particularly true for long-duration bonds, which are more sensitive to interest rate changes. However, the outlook for high-yield bonds can be more complicated during economic downturns. If the economy weakens and the risk of widespread defaults increases, the spreads between high-yield bonds and Treasuries may widen, meaning that the yields on high-yield bonds could remain elevated or even increase, despite falling interest rates.

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This dynamic creates the potential for high-yield bonds to underperform other types of bonds during a rate-cutting cycle, particularly on a price basis. Kris Keller, a manager for Columbia’s short-duration HYSD ETF, believes that short-term high-yield bonds may fare better than their longer-duration counterparts in periods of economic stress. However, the risk of defaults remains a concern. Keller stresses the importance of actively managing credit risk in the short-duration high-yield space, as there is less opportunity to offset losses with price appreciation compared to longer-term investments.

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Columbia Threadneedle’s foray into the high-yield ETF space is part of a broader trend, as several other investment firms have launched similar funds this year. Notable examples include the BlackRock High Yield ETF (BRHY) and the AB Short Duration High Yield ETF (SYFI), highlighting the growing interest in high-yield debt as investors seek out income-generating assets in a shifting interest rate environment.

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In conclusion, with Federal Reserve rate cuts on the horizon, high-yield bonds offer an appealing option for investors seeking to maintain income levels. However, careful consideration of the risks, particularly the potential for defaults, is crucial. Active management, as offered by Columbia Threadneedle’s new ETFs, can help investors navigate the complexities of the high-yield market and optimize their returns in a changing economic landscape.

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