High-yield bonds get more heft

A weak economy, dropping stock market and low interest rates are bringing a strong boom to the weakest-rated fixed-income sector — high yield — giving investors top relative returns.

“It is an attractive alternative to other asset classes,” said Robert Cook, Indianapolis-based managing director, lead portfolio manager and head of the high-yield fixed-income team at J.P. Morgan Asset Management, based in New York. His group manages just less than $6 billion in high yield.

Richard Inzunza, senior portfolio manager, Northern Trust Global Investments, Chicago, said, “On a relative basis, (high yield) looks like a pretty good return.”

“We are positive on the high-yield” sector, said Mr. Inzunza, who manages a $3.3 billion high-yield fund.

“We aren’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 total return of 26.4% for last year. “But as the economy muddles along,” high yield’s year-to-date total return was 8.69% as of the Aug. 19 close.

“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 stock index — with substantially higher volatility — was down 2.3% on a non-annualized total return basis year to date as of the Aug. 19 close.

William J. Adams, director of high-yield research, MFS Investment Management, Boston, said fear about the economy is contributing to the attraction for investors of high yield. The size of its 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.” But “we don’t need tremendous growth for the credit markets to work,” he said. “The equity market demands a higher level of growth” to rally.

Emmanuel “Manny” Labrinos, Los Angeles-based vice president and portfolio manager at Chicago-based Nuveen Asset Management, said, “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.”

As interest rates have remained 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.

None of the managers interviewed would name any specific high-yield bonds he finds attractive or is avoiding.

Fueling the high-yield market is record-high issuance. The week of Aug. 9 set an all-time record for one week for the total value of high-yield debt issued, selling some $15.4 billion from 29 issuers, said Martin Fridson, global credit strategist, BNP Paribas Asset Management Inc., New York. The previous record was $11.7 billion, from 19 issuers, the week of March 22. So far this year through Aug. 13, $141.3 billion has been issued, 72% over the record pace of 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, Mr. Fridson added.

Corporations are issuing debt to take advantage of the low interest-rate environment, triggered by a weak economy and Federal Reserve System 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 for refinancing, enabling companies to strengthen their balance sheets, said some of those interviewed for this story.

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.

The default rate on high yield also is falling, in part because of companies using lower interest rates for refinancing to improve their debt structure.

The default rate over the last 12 months is about 3%, J.P. Morgan’s Mr. Cook said.

The 12-month default rate was at a peak of 13.8% last year, Northern Trust’s Mr. Inzunza added. One projection has it declining to 2.6% by the end of this year, he added.

As Mr. Labrinos said, “The trajectory of the default rate is definitely in our favor … It is a bullish scenario for high yield.”

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. “They reduced debt, improved maturity structure, improved cost structure” and added to corporate cash reserves.

At this time, “we are still in the early stage in the recovery” of the economy, said Mr. Cook.

“A slowly improving economy is a reasonable environment for high yield,” Mr. Cook said, citing a 1% to 3% gross domestic product growth range. “We are priced for a weak or anemic environment,” Mr. Cook said.

Rough either way
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, investment analyst at BNP Paribas, wrote in an Aug. 11 report: “Double dips are a rarity, however. Most authorities identify the 1981-1982 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, they noted. Investors “who attribute less than a 25% probability to a double-dip recession should consider high-yield bonds underpriced,” Messrs. Fridson and Kong wrote. “At a minimum, we believe the market’s currently implied estimate means that high-yield investors are fairly compensated for the risk.”

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, Mr. Cook said, a point echoed by other managers. “I think in aggregate the (high-yield) market will do well over the next 12 months,” possibly returning 7% to 10%, Mr. Cook said.

Mr. Adams said, “We believe we are being adequately compensated for risk in BB and B” rated bonds.

“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, Mr. Adams said. High-yield bonds will participate in equity market upturns, he added. But high yield — because of its coupon yield — provides downside protection from the equity market, he added.

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 added.

While prices of issues the week of Aug. 9 ranged from 7% to 11%, Northern, 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, Mr. Inzunza said. The spread was 6.73 percentage points as of Aug. 17, up from 5.27% around the end of April, he said. The rise is more of a reflection of a rally in Treasury bonds.
Mr. Burr is a reporter at sister publication Pensions & Investments.