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Throughout 2015, U.S. corporate bonds have been weaker than expected.

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Overall, “the composition of total return in the U.S. fixed income market has been very interesting so far in 2015; if we look at the broad components of that market, specifically at the high-grade, high-yield and U.S. Treasury components, what we see is that corporate components have dramatically underperformed the Treasury component of the market year-to-date,” says Andrew Kronschnabel, portfolio manager at Logan Circle Partners in Philadelphia.

“As of the end of October, the high-grade and high-yield markets had returned just 0.32% and 0.25%, respectively, and that’s in contrast to U.S. Treasurys returning 0.42% year-to-date,” adds Kronschnabel, who manages the Renaissance U.S. Dollar Corporate Bond Fund.

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But that won’t be a long-term trend, he predicts. “Turning back the clock to beginning of this year, many market participants would have suggested that U.S. Treasurys were in a position to exhibit negative total return for the year, but they’ve been the star performer in the U.S. fixed-income market. [However], we don’t expect the same result going forward.”

For many years, he notes, “we’ve heard the calls for higher interest rates in the U.S. markets and we think we’re finally on the precipice of [rates] moving higher.”

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Further, “we believe that higher all-in yields—also known as the component of spread and Treasury yield in a corporate bond—will be supportive for spreads going forward. And, gradually higher interest rates will allow for high-grade and high-yield to outperform the government component of the market.”

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What he’s invested in

In the U.S. corporate bond fund that Kronschnabel manages, he holds a combination of corporate bonds and government bonds. “Within the corporate bond space, we own a combination of high-grade and high-yield, or non-investment-grade, bonds.” Currently, he says, the breakdown between the two latter types is 80% versus 20%.

Kronschnabel adds the fund currently owns bonds from issuers in the telecom and bank space. He also owns bonds that are tied to industrial spaces such as retail, pharmaceutical and, to a lesser degree, energy.

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The reason that he owns corporate bonds, in addition to government bonds, is so he can capture the spread over Treasurys with which corporate bonds trade. He explains, “In the yield of a corporate bond, there are two components: the Treasury yield, and the spread versus Treasurys. For example, [high-grade] corporate bonds currently trade approximately 170 basis points over Treasurys, to yield 3.5%. And high-yield bonds trade roughly 550 basis points over Treasurys, to yield about 7.5%.

So, “where the Treasury markets are yielding 550 and 170 basis points less than corporates, that’s the increased yield the fund achieves by owning those components of the market.”

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Originally published on Advisor.ca

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