Stuck between Treasuries and stocks? Try junk

As declining yields on Treasuries drive investors away from safety to the more volatile stock market, advisers looking for a sweet balance of risk and reward should check out high-yield bonds.

Even at historical low yields of about 7%, high-yield corporate debt stacks up favorably against the S&P 500, which has a dividend yield of less than 2%. That means stocks, which are a lot more volatile than bonds, would need to gain at least 5 percentage points of performance just to keep up with a more predictable 7% return by high-yield bonds.

Of course, there’s no question that stock market valuations are currently attractive, including a projected 37% increase in 2010 corporate earnings. And the $600 billion second round of quantitative easing, which is designed to trigger some inflation, also bodes well for stocks and not so well for most bonds.

But with regard to overall fixed-income allocations, financial advisers should keep in mind that high-yield bonds often march to the beat of a different drummer.

For example, one of the biggest threats to fixed income right now is that a sudden spike in interest rates — currently at historic low levels — would further wipe out returns. According to an analysis of the biggest interest rate moves over the 20-year period through June 2006, high-yield bonds are remarkably resilient against interest rate volatility.

Between September 1987 and June 2006, there were six separate 12-month periods that saw the yield on the 10-year Treasury climb by between 117 and 222 basis points. The average total return of high-yield bonds for those same 12-month periods was 5.5%, with just one negative-return period.

In comparison, the average total return for investment-grade corporate bonds over the same periods was a loss of 0.1%, including three negative-return periods.

Of the six 12-month periods, the worst performance for high-yield bonds was a decline of 1.57% in 1994, when the Treasury yield climbed by 204 basis points. Over the same period, investment-grade bonds fell by 3.34%.

The best 12-month period for high yield was through May 2004 when the bond category gained 13.23% on a 130-basis-point gain in the Treasury yield. Investment-grade bonds over the same period fell by 0.47%.

One of the main reasons high-yield bonds are able to weather interest rate volatility is the yield “cushion,” according to Sabur Moini, manager of the $1 billion Payden High Income Fund (PYHRX). For example, the current 6.8% average yield on high-yield bonds compares with a 3.8% average yield on investment-grade bonds.

“The bigger yield cushion makes high-yield bonds a lot less interest-rate-sensitive,” Mr. Moini said.

High-yield bonds, as measured by the Merrill Lynch U.S. High Yield Constrained Index, gained 14% this year through Nov. 21. That represents a significant cool-down from the benchmark’s 56.8% gain last year, but it doesn’t necessarily represent the end of the road for high yield.

“Typically, low growth, but not in a recession, is the best environment for high-yield bonds,” said Michael Collins, co-manager of the $700 million Prudential Total Return Bond Fund (PDBAX). A little bit of inflation and projected economic growth in the 2% to 2.5% range “is almost the sweet spot for high yield,” he said.

If economic growth is too low, high-yield companies can have trouble paying off their debt. And if the economy grows too rapidly, forcing the Federal Reserve to fight inflation with higher interests rates, all risky assets tend to suffer.

But low levels of inflation can work to give high-yield companies enough pricing power to improve their balance sheets.

Investor reluctance to consider high-yield bonds may have something to do with current yields’ being about 3 percentage points below their 10% historical average, according to Mr. Collins.

“Some people might have some sticker shock,” he said. “They see 7% on a high-yield bond and they think it looks more like middle yield.”

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].