A weak economy, a poor equities market and low interest rates have been a boon to high-yield junk bonds.
A weak economy, a poor equities market and low interest rates have been a boon to high-yield junk bonds.
“It is an attractive alternative to other asset classes,” said Robert Cook, a managing director, lead portfolio manager and head of the high-yield fixed-income team at J.P. Morgan Asset Management. His group manages just under than $6 billion in high yield.
“On a relative basis, [high yield] looks like a pretty good return,” said Richard Inzunza, a senior portfolio manager at Northern Trust Global Investments.
“We are positive on the high-yield” sector, said Mr. Inzunza, who manages a $3.3 billion high-yield fund.
Northern Trust isn't “bullish to the extent we expect the return of 2009,” which was 57.5% on a total return basis, compared with the S&P 500's total return of 26.4%, he said. This year, with market volatility and sluggish growth, high yield's year-to-date total return was 8.69% as of Aug. 19.
“Even if the market stays flat, you are looking at 8.45% yield,” and that is better than other asset classes, Mr. Inzunza said. As he pointed out, investment-grade corporate bonds are yielding 3% while Treasury bond yields are even lower and the S&P 500 was down 2.3% on a non-annualized total return basis year-to-date as of Aug. 19.
Fear about the economy is contributing to the attraction for investors of high yield, said William J. Adams, director of high-yield research for MFS Investment Management. The size of the firm's high-yield portfolio wasn't available.
“There are ... fears of rolling over to a double-dip or second recession and fears of inflation,” Mr. Adams said. “You are seeing uncertainty in the equity market.”
However, “we don't need tremendous growth for the credit markets to work,” Mr. Adams said. “The equity market demands a higher level of growth” to rally.
“People have shied away from equities. Most of the money coming out of equities is going into bonds ... up and down the spectrum, from Treasury to high-yield securities, said Emmanuel “Manny” Labrinos, a vice president and portfolio manager at Nuveen Asset Management.
With interest rates remaining low, investors “have been looking for [fixed-income] alternatives to get more return than Treasuries and safer corporates without taking much risk,” and turning more to high yield, said Mr. Labrinos, whose taxable fixed-income group manages $1.8 billion, including investment-grade and high-yield bonds. A breakout of the high yield was unavailable, he said.
Fueling the high-yield market is record-high issuance. The week of Aug. 9 set an all-time record for the total value of high-yield debt issued, with 29 issuers selling $15.4 billion of bonds, said Martin Fridson, a global credit strategist at BNP Paribas Asset Management Inc.
The previous record was $11.7 billion, from 19 issuers, the week of March 22. Through Aug. 13, $141.3 billion has been issued this year, 72% over the record pace last year.
Investors have been attracted to high-yield bonds “in response to low yields on Treasury bonds and low prospective returns on stocks in light of the slow growth in the economy,” Mr. Fridson said.
“High yield could be the best performer” of the major asset classes for the year, he said.
Corporations are issuing debt to take advantage of the low-interest-rate environment, triggered by a weak economy and Federal Reserve efforts to keep rates low by setting the target federal funds rate between zero and 0.25%.
Some 60% to 70% of the high-yield issues this year are intended to help companies refinance and strengthen their balance sheets.
Even in this weak economy, “companies can withstand a low-growth environment” because of refinancing to lower interest rates and extending debt maturities, Mr. Adams said. Refinancing at lower interest rates has also helped reduce the default rate on high yield.
The default rate over the past 12 months is about 3%, Mr. Cook said.
The 12-month default rate set a record of 13.8% last year, Mr. Inzunza said. One projection has it declining to 2.6% by the end of this year, he said.
“The trajectory of the default rate is definitely in our favor ... It is a bullish scenario for high yield,” Mr. Inzunza.
As Mr. Adams pointed out, “companies have made enormous strides in improving their balance sheets [in debt structure] because of the pain they've gone through” in the 2008 financial market crisis.
At this time, “we are still in the early stage in the recovery” of the economy, Mr. Cook said. “A slowly improving economy is a reasonable environment for high yield,” he said, citing a 1% to 3% gross domestic product growth range.
A recession would raise the hurdles for companies already under financial stress, while a fast-growing economy could cause rising interest rates and overoptimism, leading to overexpansion, portfolio managers said.
In terms of a high-yield outlook, Mr. Fridson and Vince Kong, an investment analyst at BNP Paribas, wrote in an Aug. 11 report: “Double dips are a rarity. Most authorities identify the 1981-82 recession, which followed close on the heels of the 1980 recession, as the only post-World War II example.”
Investors collectively appear to assign a 25% probability to a double-dip recession. Investors with that outlook “should consider high-yield bonds underpriced,” Mr. Fridson and Mr. Kong wrote.
The outstanding high-yield market is valued at more than $1 trillion from some 1,000 issuers, Mr. Cook said. “You can build a well-diversified portfolio,” he said.
“We think you have to be more selective” than in more bullish markets like last year's, Mr. Cook said. “I think in aggregate, the [high-yield] market will do well over the next 12 months,” possibly returning 7% to 10%, he said.
“We believe we are being adequately compensated for risk in double-B and B” rated bonds, Mr. Adams said.
“People tend to think of high-yield exposure as part of fixed-income exposure,” but it is better to look at it as part of equity exposure, he said. High-yield bonds will participate in equity market upturns, Mr. Adams said.
But high yield — because of its coupon yield — also provides downside protection from the equity market, he said.
Northern Trust looks to better-quality high yield for its portfolio, in part because of the economic uncertainty, Mr. Inzunza said. “We probably give up some higher yield” by avoiding lower-quality credit, he said.
Although prices of issues the week of Aug. 9 ranged from 7% to 11%, Northern Trust, for instance, bought issues in the 7% to 9% range, Mr. Inzunza said.
Despite the investor interest in the low-rated debt issues, the spread of high yield rates to Treasury rates has widened since spring, he said.
The spread was 6.73 percentage points as of Aug. 17, up from 5.27 percentage points around the end of April, Mr. Inzunza said. The rise is more of a reflection of a rally in Treasury bonds.
Barry B. Burr is a reporter at sister publication Pensions & Investments.
