Balancing optimism and pessimism

Although markets are now somewhat calmer, the crisis is far from being fully resolved. “It’s a multi-year problem,” says Carr. “All you can really hope for is some gradual progress. As we get progress, credit markets should react favourably. If, on the other hand, we get a crisis of confidence, then Europe will have an impact. This remains an outstanding risk we have to work through.”

Spreads for high-yield bonds over U.S. treasuries have dropped to about 700 basis points from almost 900 bps in October. That means they are yielding 8.14%, according to the benchmark Merrill Lynch high-yield master II constrained index. “The spread is about 175 bps above the long-term average, which makes the asset class cheap,” says Carr. “That being said, the risks out there keep the spreads above normal levels.”

Although Europe appears uncertain, the U.S.’s macroeconomic picture is getting better, says Carr, who works alongside Richard Kos, vice president of Manulife AM. Carr points to falling unemployment levels and growing stability in the housing sector. “It’s obviously good for Canada, given our close trade ties,” Carr says. “Ultimately, the U.S. economy is more important for high-yield bonds than the European economy. So, we have some mixed signals: more positive signals coming out of the U.S., but concerns about Europe.”

Carr says Europe could either get worse and high-yield bonds would suffer. Or matters could improve in both North America and Europe. “The second situation is a little more probable,” says Carr. “I’m looking at returns of 7%-10% based on the constructive base case and some of the progress we saw in late 2011.”

From a strategic viewpoint, Carr and Kos run a mix of high-yield bonds and investment-grade corporate bonds, with about 52% of the Manulife fund’s assets under management in high-yield issues. The fund’s average bond duration is 4.75 years, almost two years shorter than the DEX universe bond index.

Representative holdings among the approximately 200 positions include Newalta Corp., a waste-removal services firm whose 2019-dated B-rated bond is yielding 7.4%.

 

although the u.s.’s economic fundamentals have been improving, Europe’s sovereign- debt problems and banking sector are the major stumbling blocks, agrees Greg Kocik, managing director with Toronto-based TD Asset Management Inc. and manager of TD High Yield Bond Fund.

“The big issue,” Kocik says, “is which banks and countries will shoulder the greatest pain, and losses, from their exposures.”

Establishing this would be a quick exercise for an overleveraged company, but it’s a much more complex issue when dealing with a country such as heavily indebted Greece, whose junk-status bonds are held by many French and German banks — which, as a result, will eventually require major infusions of capital.

That is why patience is required to reach a positive outcome, says Kocik: “It’s not going to take a weekend meeting and an announcement that everything has been resolved. We’re dealing with 17 governments and parliaments, and a democratic process. But the market is hoping for some kind of indication that ‘OK, we have turned a corner and decided to move forward with this decision. It may take a year or two to implement, but at least we are moving forward.’ We’re still waiting for that decision. All this introduces uncertainty into the financial system and makes people less willing to assume risk.”

Kocik sees two possible scenarios in 2012: the Europeans don’t reach a decision, which triggers an uncontrolled default by countries such as Greece and seriously affects some regional banks; or Germany and France reach a decision in the next few months and agree to a degree of fiscal harmonization.

“This [second] path could take 10 years to implement,” he adds, “but at least they could say, ‘Here’s the path’.” He favours this scenario.

Meanwhile, Kocik notes, the European Central Bank will help regional banks by buying some of their sovereign debt and improving market liquidity.

Kocik had been cautious before last summer’s sell-off but used that opportunity to increase some holdings in the TD fund. Currently, the fund’s 7.4% yield is slightly higher than the 7% yield for its benchmark, Bank of America Merrill Lynch U.S. high-yield BB-B index. Kocik has reduced cash held in the TD fund to 3% of AUM from 8% last summer. The fund’s average duration is 3.4 years, vs 4.8 years for the fund’s benchmark.

“We think that a 2% yield for U.S. treasuries makes no sense,” says Kocik, who expects that high-yield bond funds’ returns could reach around 7% in 2012. “But over the next few years, as risk aversion declines, the government bond market could sell off. To mitigate the effects of that move, we’re being cautious and keeping the duration low.”

The TD fund’s holdings include Ford Credit Canada Ltd., whose 2014-BB-plus rated bond is yielding 4.1%; and Goodyear Tire & Rubber Corp., whose 2020 B+ bond is yielding 6.8%.

Sharing an equal blend of optimism and caution is Frank Gambino, vice president of Toronto-based RBC Global Asset Management Inc. and co-manager of RBC Global High Yield Bond Fund, who shares duties with Jane Lesslie, vice president and senior portfolio manager with RBC Asset Management (U.K.) Ltd. in London.

“It’s always difficult to make any predictions,” says Gambino. “But it’s especially difficult, given all the macro factors that are going on. We’re dealing with Europe — a sovereign-debt crisis, a banking crisis and a region that is likely to go into recession. And a potential slowdown in the U.S., although it is likely to avert recession. China is starting to slow down, too. There are a lot of risk factors, not to mention U.S. fiscal policy, which still has to be sorted out.”

In spite of all the challenges, Gambino expects that high-yield bonds will return 7%-9% in 2012. This positive view is based on attractive valuations, strong demand for high-yield bonds from institutional investors, low interest rates and improving corporate fundamentals.

“Companies have an ample cushion to pay us, as investors,” says Gambino. “Default rates are quite manageable — at 1.75%, according to J.P. Morgan. There have been some defaults, but it’s not a systemic problem; it’s company-specific.” (Gambino points to the collapse of U.S.-based utilities such as Dynegy Inc. to support this argument.)

Meanwhile, investors are looking for alternatives to government bonds, whose yields are at rock-bottom levels. “When you compare the 6%-8% on a high-yield bond to a U.S. treasury bond paying less than 2%, you can get quite a bit of value,” says Gambino, adding that equity fund managers have been augmenting their stock selection with high-yield bonds.

Gambino and Lesslie run a fund that is a roughly 50/50 blend of high-yield and emerging-market bonds; the J.P. Morgan emerging-markets bond index and Bank of America Merrill Lynch U.S. high-yield BB-B index are the fund’s benchmarks. Currently, the RBC fund holds 46% of AUM in high-yield and 52% in emerging-market issues, along with about 2% cash. The fund’s average duration is 5.5 years.

“On a fundamental basis, there is better value and opportunity on the high-yield side,” says Gambino, adding that he has shifted to higher-quality issues in this sector. “But our technical models also say we should overweight this area, as opposed to emerging markets.”

Among the 160 names in the RBC fund is Reynolds Group Inc., a New Zealand-based global maker of packaged goods such as aluminum foil wrap, whose BB-rated bond, callable in 2016, yields 6.3%. Another prominent holding is Host Marriott Corp., a U.S.-based real estate investment trust that owns the Marriott and Sheraton hotel chains, whose 2020 bond (rated BB+) yields 5.37%. IE