High-yield bonds are attractive plays at the moment, compared with government bonds that pay very little and investment-grade bonds that don’t yield as much as many clients need. But the big issue remains: how much risk are you running with these investments?
The high-yield (a.k.a. “junk”)market is relatively strong, says Lorne Steinberg, president of Montreal-based Lorne Steinberg Wealth Management Inc., which sponsors the $30-million Steinberg High Yield Fund; it holds North American non-investment-grade debt.
In fact, the Merrill Lynch Master II High Yield Index shows junk yielding 568 basis points (bps) over U.S. treasuries of similar duration. After the dot-com flop in 2000, this spread went to 1,200 bps. In the winter of 2008-09, it was at 2,000 bps. Now, it is closer to the low of 249 bps hit in February 2007.
The relatively tight spreads between high-yield debt and government bond yields reflects the actions of the U.S. Federal Reserve Board and other central banks, explains Barry Allan, president and CEO of Marret Asset Management Inc. in Toronto. Normally, in economic slowdowns, junk defaults rise. In 2008, it was homebuilders and financial services firm that suffered. But in the current environment of sluggish global growth, there is no industry bias, as cheap money has suppressed default rates in all sectors.
Moreover, the high-yield market itself is relatively stable. In 503 rating actions in 2012 (as of mid-December), Toronto-based DBRS Ltd. downgraded just 5.4% of bond issues the credit-rating agency reviewed, vs 2.4% that were upgraded; the majority had their ratings unchanged.
Currently, there are attractive high-yield bonds in resources. If you assume that China’s economy will not have a hard landing that would pull down commodities prices, Allan says, then high-yield bonds such as the B-rated Athabaska Oil Corp. 7.5% issue due Nov. 19, 2017, recently priced at par, offers good value at reasonable risk. The yield is 623 bps over a Canada 1.27% bond due Sept. 1, 2017, recently priced at par.
@page_break@Investing outside of North America is another matter. Steinberg, for one, is not buying European high-yield sovereign debt: “Sovereign defaults, in the case of Greece, and the threat of defaults in Spain, Portugal and Italy are the problem. It is very hard for creditors to claim assets in a foreign country. Argentina which defaulted in December 2001, taking down one-seventh of all debt in the developing world is proof of that. So, we prefer to stay in North America, where there is a rule of law.”
But there are good values to be had in “BRIC” (Brazil, Russia, India and China) bonds in local currencies, says Nick Chamie, head of emerging-markets research for Royal Bank of Canada’s capital markets division in Toronto. He notes that BRIC and other emerging markets’ bonds pay higher yields such as 7%-8% on one- to two-year Brazil government issues denominated in reals. And in Russia, he notes, yields hover around 6.5% for five-year government bonds. There is also the potential for currency appreciation.
But emerging-market bonds traded in Canada are exotics that seldom have secondary markets. When issued by companies in the BRIC markets, they may be available at issue, but they present all the risks of conventional bonds plus major liquidity concerns.
“Access is a problem,” Chamie says. “But Russia will soon have its government bonds cleared through Euroclear in Brussels, so settlement and interest payments will be quicker and simpler. BRIC bonds issued in their own currencies are handicapped by the lack of exchangeability of their currencies, which are not internationally traded. Institutional investors can set up local accounts for these bonds, but it is hard for retail investors to do that.”
For clients with a taste for more risk than is found in domestic bonds, foreign high-yield bonds offer enhanced yield and a gain if the currencies in which they are issued appreciate against the Canadian dollar. However, when foreign-currency bonds are hedged back to Canadian dollars, the yield pickup often disappears.
Emerging-market bond-based exchange-traded funds offer easier access. Although there are higher yields in BRICs and other foreign fixed-income assets, there’s also more risk, so holding a basket of issues makes sense.
The risk in investing directly in foreign issues lies partly in political risk and partly in the difficulty in doing due diligence in remote markets in which corporate governance and the legal system may be questionable.
As Chamie notes: “There is no lack of history of defaults [during] financial crises.”
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