Rate cut seen as positive for high-yield-bond investors

After being beaten down as a result of the subprime-mortgage mess, junk bonds now look like big winners following last week’s interest rate cut by the Federal Reserve. And some industry experts say that that may translate into a sustained rally that will benefit investors. Those who sell junk bonds were finally able to start to move more than $300 billion of high-yield debt sold to finance leveraged-buyout activity this year, said Christopher J. Towle, a portfolio manager for several high-yield-bond products offered by Lord Abbett & Co. LLC of Jersey City, N.J. Those include the Lord Abbett Bond-Debenture Fund and the Lord Abbett High Yield Fund. Big sale R.H. Donnelly Corp. of Cary, N.C., issued $1 billion in junk bonds a day after the Fed’s decision last Tuesday to cut the federal funds rate by half a point to 4.75%, Mr. Towle said.
The sale, which he said was well received, was the first major bond deal to be finalized in the past couple of months. Wall Street very much wants to get other such deals done before the end of the year, and that will present high-yield-fund managers with some very good buying opportunities, Mr. Towle said It is the beginning of a “happy ending” to recent junk bond underperformance, he said. High-yield-bond-fund average returns were near the bottom of all taxable-fixed-income categories last week, according to Morningstar Inc. of Chicago. The high-yield-fund category had an average return of 2.18% year-to-date as of last Wednesday, ranking it just above the long-term-bond-fund category, which had an average return of 2.01%, and the bank loan fund category — the worst-performing taxable-fixed-income category — which had an average return of 0.86%, according to Morningstar. Some financial advisers agree that junk bonds will soon start to look better to investors. “I think things might start improving a little bit,” said Morris Armstrong, president of Armstrong Financial Strategies in Danbury, Conn. As a result, it might be a good time for investors to revaluate their portfolios, and high-yield bonds should be part of the revaluation, he said. “If you look at high yield as being a separate asset class, you should have some exposure unless you think the world is falling apart,” Mr. Armstrong said. Few advisers, however, said they would recommend that investors start to increase their exposure to high-yield bonds based on the Fed’s move. “Short term, both the credit and equity markets have responded favorably to the rate cut, but it remains to be seen what the intermediate implications are,” said Bob Kargenian, president of TABR Capital Management LLC in Orange, Calif. Certain issues that made high-yield bonds unattractive before the rate cut remain, he said. Tight spreads For example, even though spreads between high-yield bonds and U.S. Treasuries have widened as a result of the Fed’s action, they are still historically very tight, Mr. Kargenian said. That means investors aren’t being rewarded enough for the extra risk of investing in junk bonds, he said. Another problem is that “it is hard to imagine the default rate, which is below 2%, doing anything but [going] higher, which should cut into future returns,” Mr. Kargenian said. Such issues make Peter Regan, president of CEP Financial LLC of Houston, leery of the high-yield sector. The Fed’s move does “bail out” junk bond issuers and underwriters who haven’t been able to bring their bonds to market, but it doesn’t change the fact that the deck appears to be stacked against them when it comes to any kind of sustained market revival, he said. High-yield-bond-fund managers, however, are optimistic. Although Sandy Rufenacht, the well-regarded chief investment officer and principal owner of Three Peaks Capital Management LLC in Greenwood Village, Colo., said he doesn’t expect junk bonds to light the world on fire, the asset class is “reasonably positioned” to outperform Treasuries and “hang in there” with stocks. Tree Peaks is the subadviser to the Aquila Three Peaks High Income Fund, which he manages for Aquila Asset Management LLC of New York. Relatively low default rates, widening spreads and the Fed’s showing that it will be accommodating are all positive signs, said Mr. Rufenacht, who made a name for himself managing the Janus High-Yield Fund. He managed the fund, offered by Janus Capital Management LLC of Denver, until July 2003, when he and the Janus high-yield team set out to launch Three Peaks Capital Management. But managers will have to be selective about what they buy, Mr. Rufenacht said. It is in the best interests of the firms that underwrote the high-yield bonds to bring the deals to market as early as possible to get them off their books, he said. Selectivity is key Not all those deals, however, will be worth investing in, Mr. Rufenacht said. Being selective is key, agrees Eric Takaha, senior vice president and director of corporate/high yield at Franklin Templeton Investments in San Mateo, Calif. Now is a good time to buy high-yield bonds, but for Franklin, that means focusing on junk bonds that are at the higher end of the quality spectrum, he said. Investors and fund managers who are too focused on quality, however, could miss out on the opportunity that the Fed’s move has created in the high-yield market, Mr. Towle said. When the high-yield market bounces back, the lowest-quality junk bonds usually benefit most, he said. That is one reason why Mr. Towle tries to keep his portfolio “balanced” among bonds that range from high to low quality on the junk bond scale, he said. David Hoffman can be reached at dhoffman@crain.com.