High-yield bonds produced fairly low returns last year, indicating a slowing pace after several years of relatively strong gains. Economic conditions are buoyant, which is key to the health of so-called “junk” bonds, yet fund managers are divided on whether attractive valuations still exist.

In the positive camp sits Jerry Domanus, manager of Standard Life Corporate High-Yield Bond Fund and vice president of corporate bonds and private placements at Montreal-based Standard Life Investments Inc.

“We have decent economic growth, low inflation and no inflationary fears,” says Domanus. Corporate profits are solid and firms enjoy low borrowing costs and narrow spreads over government issues (a.k.a. treasuries).

“All this has resulted over the years in strong liquidity and credit quality. Default rates are at a record low,” he says. Default rates in the U.S. junk market are less than 1.5%, vs 11% a few years ago. “Besides, rating agencies’ upgrades are in balance with downgrades. These are all positives.”

Conversely, Domanus points to high and volatile energy prices and rising short-term rates. The combination could curb consumer spending. It hasn’t happened yet — but investors should be mindful.

In general, he notes, companies are focusing on “shareholder-friendly” activities, such as boosting dividends or buying back shares, rather than retiring debt. “Companies are sitting on piles of cash, and are more likely than before to make an acquisition by paying cash or issuing debt rather than issuing equity,” he says.

As a rule, corporate spreads over treasuries start to narrow when companies pay down debt and their balance sheets improve. “This isn’t happening any more; the trend is pretty much over,” says Domanus, who still anticipates coupon-like 5%-6% returns in 2006. “The risk is it could stay the same, which is fine. Or some companies may start to releverage, and increase debt through acquisitions. It might be good for shareholders, but not bondholders. Spreads could widen and bond prices fall.”

Strategically, he takes a hybrid approach to his fund, which can be regarded as a low-quality corporate bond fund with an average rating of BBB. In terms of mix, about 25% of the portfolio is in A-rated bonds, 45% in BBB bonds and 30% in BB and B-rated, or junk bonds. The average term to maturity is 13.5 years. In the past year, as new money has flowed into the fund, he has increased the names to 35 from 25, reducing risk through diversification.

On a sectoral basis, 36% of the portfolio is invested in utilities and infrastructure names, including Greater Toronto Airport Authority, TransCanada PipeLines Ltd. and Westcoast Energy Inc. He has 26% in cable and telecommunications, 16% in natural resources, 9% in a mix of retail-consumer, real estate and financial services, and 3% in cash.

Among the more recent acquisitions is a Shaw Communications Inc. BB-rated bond maturing in 2012. Its yield is 6.1%. Another favourite is a BB-rated Rogers Wireless Inc. bond that matures in 2011 and yields 6.1%. Domanus also likes Cameco Corp., a world-leading uranium miner based in Saskatchewan. “There is a shift back to nuclear energy, and companies are extending the lives of reactors. This company is doing quite well,” he says. Cameco’s bond matures in 2015 and yields 5%.

He has added other names, including Molson Coors Corp., whose 2015-maturing bond yields 4.8%, and Métro Inc., the Quebec-based supermarket chain that recently acquired A&P Canada. “Métro has a history of not liking debt. It is one of the few ‘de-leveraging’ stories,” he says, adding that the BBB-rated bond, which matures in 2035, has a 5.8% yield.

Jeff Hall, manager of Investors Canadian High-Yield Income Fund, observes that last year was a more pedestrian year, without a lot of volatility. In contrast, he notes, 2003 and 2004 were better because of the greater opportunities that developed in 2001, when yields soared because of concerns about credit quality.

“Returns in 2005 were much as expected, given the price of the asset class at the start of the year. It was coming off high levels of overall valuations,” says Hall, a partner at Winnipeg-based I.G. Investment Management Ltd. “Therefore, to see a low- to mid-single-digit return was within expectations.”

The benchmark Scotia Capital high-yield bond index returned 3% in 2005; in contrast, the SC universe bond index rose 6.3%.

Hall is cautious about prospects. “There is too much leverage in all parts of the system,” he says. Looking to the next six months, he does not see conditions that could be negative for credit markets; they are close to being “priced for perfection,” he adds. “The market is priced for good times continuing. It might be the case, but the risk/ return scenario favours a lower weighting in these riskier assets.”

@page_break@Because of his concerns, Hall has maintained an exposure to high-yield bonds that is closer to the mandated lower limit. In 2004, the weighting was as high as 70%. Now, however, his high-yield bond exposure is less than 40%. The balance is a mix of investment-grade bonds, convertible debt, mortgage-backed securities and non-rated securities.

Within the high-yield weighting, Hall favours the Canadian cable and telecommunications industries. The sector has consolidated in recent years, he notes, resulting in firms with better balance sheets and, by extension, lower bond yields. At the same time, he argues, “It’s no longer an area in which you can get a large capital appreciation. But it should be pretty stable in its returns — 6%-7% on debt that has recently been issued.”

Hall holds bonds issued by Rogers Wireless, Cogeco Cable Inc., Shaw Communications and BCE Inc. He also has less than 10% in the U.S., most of which is in the so-called “distress and recovery” market. For instance, about 18 months ago, he acquired bonds issued by Mirant Corp., a large electrical generator that was swept up in the Enron Corp. fiasco and had entered into some poor contracts that ultimately forced it to default on its bonds.

Hall came into the picture when the firm was in Chapter 11 and its prospects were beginning to look better. “We held straight and convertible debt that was very inexpensive and earned a very significant return,” he says, adding that he took a “total return” approach, not simply a call on interest rates. The main Mirant holding (he holds another a smaller position) matures in 2021, but was converted into equity early this year.

“This is part of our strategy,” he says. “Whether you own the bonds or the stock, you have to ask, ‘Will it be a viable company when it is re-structured, [and] are you prepared to carry this through?’”

In general, Hall has modest expectations going forward: “The era of large double-digit returns is mainly behind us — until there is a change in the credit cycle. We’re at the top of the cycle, and the outlook for returns could be the same as 2005.”

Dan Bastasic, lead manager of Mackenzie Sentinel Corporate Bond Series A and vice president of investments at Toronto-based Mackenzie Financial Corp. , is more upbeat. From a macro perspective, he concedes that the opportunities for easy investments in high-yield bonds are much fewer and far between than a few years ago.

A value-oriented, bottom-up investor, Bastasic nevertheless says: “I would rather see a range-bound market, such as the one we are going to be in for the next year to two years. There are many arguments that suggest we’re going to be in this kind of environment.”

Like Domanus, he notes that, from a fundamental viewpoint: “High-yield issuers are enjoying the strongest balance sheets and income statements and cash flows than at any time in the past 40 years. Defaults are around 2%, which is a pretty low rate in the high-yield environment.”

Bastasic adds that the average spread over treasuries in the past 20 years has been 420 basis points; the average spread is currently around 370 bps. “The question is: is the market fairly valued or overvalued? From my perspective, it’s the former. The fundamentals are better than they’ve been for years.”

Bastasic, who uses cash as a strategic asset, raised cash significantly in 2005 as the high-yield market was roiled by concerns about the automotive sector in the U.S. General Motors Corp., for instance, saw its bonds downgraded to junk status. By October, cash hit 20% as Bastasic sought to avoid a falling market.

His cash holdings were recently 15%, as values have cropped up. “Certain names were way too undervalued relative to the perceived risks,” he says. About 75% of the fund is in high-yield bonds, with about 10% in convertible bonds and income trusts. The fund, which holds about 40 names, has an average term to maturity of 6.7 years.

One new holding is Jean Coutu Group Inc. A leading Quebec-based drug-store chain, its 2014-maturing bonds were under pressure because of concerns about its acquisition of the Eckerd’s drugstore chain in the U.S. in 2004.

“Prices were trading around 94¢ on the dollar. I saw a lot of total return potential, relative to what the market priced in,” he says.

The firm is well run and will need more time than originally planned to meet its financial targets. “There is a lot of value in the organization,” he adds. “It has a good business model for high-yield.”

The bond, which is priced in U.S. dollars, yields 9.7%. The bulk of the fund’s US$ exposure, he adds, is hedged back into Canadian dollars.

Another new acquisition is Cogeco. “Its bonds are stable cash-flow-producing assets, and it seemed the firm could improve its cash flow based on its penetration of new areas, such as voice-over-Internet protocol, which it introduced last year,” says Bastasic.

The bond matures in 2009, is denominated in C$ and yields 6%, about 295 bps over treasuries. IE