High-yield bonds had a significant rally in 2009, thanks to massive government intervention that restored confidence to crisis-plagued markets. And managers of high-yield bond funds expect good returns this year, although not of the same magnitude as last year, when conditions brought about a dramatic cut in interest rates.

“One of the big factors [in 2010] is the improving economy — the fundamentals are much improved compared with a year ago,” says Frank Gambino, lead manager of RBC Global Corporate Bond Fund, co-manager of RBC Global High Yield Bond Fund and vice president at Toronto-based RBC Asset Management Inc. : “In late 2008, everyone used the Great Depression analogy. Thankfully, we averted that, and now it’s the Great Recession. North American economies are stabilizing, and that’s a very positive thing for corporate bond markets. It’s leading to a much better credit profile for corporations.”

In hindsight, markets were shaken by the disappearance of liquidity, notes co-manager Jane Lesslie, vice president and senior portfolio manager with RBCAM in London, England. “On top of that,” she adds, “there was massive counter-party risk, which had to be priced. There was not much precedent for that.”

An emerging-markets specialist, Lesslie says that a key turning point occurred last spring, when the G20 countries bolstered the resources of the International Monetary Fund and the World Bank, allaying liquidity concerns in emerging markets.

Gambino concurs that sentiment turned last spring, when so-called “money centre” banks in the U.S. reported better earnings than expected. “That was the jolt the market needed,” he says. “As 2009 unfolded, and economic activity started to improve, a lot of money moved into the asset class. Because there is no money to be made in cash accounts, this was a way to ease back into riskier assets. So, we had an exceptional rally off the bottom.”

Gambino notes the average high-yield bond fund returned 27.5% last year. Moreover, if the economy continues to improve, spreads over government bonds are expected to narrow. “We are positive on the macro credit environment and valuations are still attractive,” he says. “But it could be a fairly negative year for government bonds, which are more vulnerable to interest rate changes.”

For instance, even if high-yield bonds return only 4% in 2010, government bonds could see losses of around 3%, says Lesslie: “It is still a fairly decent excess return for owning high-yielding portfolios. They are certainly protecting you against an increase in Treasury rates brought about by expectations of an improving economy.”

RBC Global High Yield Fund has a 50/50 split benchmark, using the Citigroup high yield index and the JP Morgan emerging markets bond index. In the current environment, 46% of the RBC fund’s assets under management is in emerging markets, 52% is in North American high-yield bonds and 2% is in cash. Besides a hedging program that covers much of the U.S. dollar-denominated bond exposure, there are about 165 holdings, including bonds issued by Turkey, Indonesia and U.S. firms such as Qwest Corp. The average duration is six years.

RBC Global Corporate Bond Fund is benchmarked against six indices, dominated by the Barclays U.S. aggregate credit subindex (in Canadian dollars). About 41% of AUM is in U.S. investment-grade bonds, 11% is in U.S. high-yield bonds, 15% is in Canadian corporate bonds, 10% is in emerging markets, 18% is in Europe and 5% is in cash. This fund is highly diversified and has more than 400 securities, with larger holdings from issuers such as Goldman Sachs Group Inc. and General Electric Capital Corp.

“Given that we have a more supportive credit backdrop, we’re comfortable taking on a little more credit risk,” says Gambino, noting that the average duration in the corporate bond fund is 5.3 years and its portfolio is of a higher quality than its sister fund. “We’re increasing our allocation to financials and BBB-rated bonds.”



As the risks have subsided, markets are moving back to more normal conditions, says Tom Nakamura, co-manager of both AGF Canadian High Yield Bond Fund and AGF Global High Yield Bond Fund with Toronto-based AGF Investments Inc.

“Markets are looking at cyclical economic factors instead of extreme economic stresses,” he says. “With interest rates at very low levels, we expect that over the next 12 to 18 months, all the major central banks — with the exception of Japan — will start normalizing their policy rates. [That] will have profound implications for all asset classes, including high yield.”

@page_break@Rising interest rates are a concern, as the U.S. is creating a massive supply of bonds to fund its US$1.7-trillion deficit. However, one of the biggest traditional buyers of that new supply — the U.S. Federal Reserve Board — will be absent and thus create a supply/demand imbalance.

“We are looking at higher government yields across the world. Economies are on the mend and will see fairly moderate growth,” says Nakamura. “There are still some supportive elements for high-yield markets because of the [improving] economy. And because [corporate bonds] still look extremely attractive, relative to government instruments, money will continue to flow into [them].”

Nakamura, and co-manager Tristan Sones, vice president at AGF, are bullish on high-yield bonds because they are not as correlated to interest rate movements as plain-vanilla bonds are. “U.S. high-yield bonds have only an 11% correlation,” says Nakamura, “vs an 83% correlation for investment-grade bonds.”

Moreover, AGF fund managers believe that investment-grade and high-yield corporate bonds should do well because there is less supply coming into the market. “The big impact is the technical picture,” says Nakamura. “Last year, the U.S. Federal Reserve Board bought US$700 billion in [U.S.] Treasury bonds. This year, it won’t buy anywhere near that amount. Where will the demand come from? Some of it will be offset by investors. All things being equal, however, we should see higher yields down the road. From a bond perspective, we ask, ‘Where are the best opportunities?’ To us, high yield is one of the places we look at.”

So, how much upside is left? Currently, high-yield bonds are returning 600 basis points over U.S. treasuries, according to the benchmark Merrill Lynch master high yield II index, compared with 2,200 bps a year ago. “There is some room for [the spread] to come in, maybe 100 to 150 bps,” says Sones. “The best estimate for this year is a mid- to high single-digit return.”

Strategically, Sones and Nakamura are taking a mixed approach for AGF Canadian High Yield Bond Fund. The AUM of the 80- to 90-name fund consists of investment-grade corporate bonds (39% of AUM), high-yield bonds (27%), emerging markets bonds (13%), government bonds (6%), so-called “sovereign governments” (8%) and cash (about 6%). The average duration is 3.6 years. The bulk of the foreign exposure is hedged back into C$.

“Going forward, it’s going to be harder to get that extra return out of the government-bond side,” says Sones, adding that the fund managers are shifting into lower-rated bonds that have more potential to cushion against higher interest rates.

Within the 100-name global fund, there is about 30% of AUM in high-yield bonds, 27% in emerging markets, 12% in investment-grade corporate bonds, 20% in sovereign debt and so-called “supranational agencies” (such as Inter American Development Bank) and 11% in cash. “We are keeping some powder dry, so we can take advantage of new issues,” says Sones, adding that almost 50% of the fund’s exposure is in C$. “We want to stay as flexible as possible. We have a blend [of assets] that provides us with better diversification. Our cash is likely to come down over the next quarter or so.”



The economy is making a better recovery than expected, says Dan Bastasic, manager of Mackenzie Sentinel Corporate Bond Fund and vice-president, investments, with Toronto-based Mackenzie Financial Corp.

“Given what I see in terms of liquidity, consumer spending and house prices, and the fact we had a big inventory correction, we’re probably going to see 2.5%-3.5% real gross domestic product growth in 2010,” he says. “What matters is that we’re not contracting. If we are [contracting], defaults will increase and spreads will widen out — which will hurt any fixed-income asset class. That’s not what I expect.”

High-yield bonds appear to be cheap, he adds, as defaults are trending downward to around 4%-4.5% by yearend 2010, compared with a peak of 13% in 2009: “That’s a fairly positive backdrop for risk premiums to come in, which is essentially the spread.”

Bastasic anticipates that spreads between high-yield bond and U.S. treasuries will decline, possibly to around 400 bps-450 bps in 2010: “That would lead to double-digit returns again for this year. This could happen, if everything comes to fruition.” The risks, he admits, are eroding liquidity, higher than expected interest rate increases by central banks or failure for employment to improve. “I am not sure, based on what we’ve seen over the past six months, that we should see that [happen] over the next 12. There is enough momentum that we will continue to improve, from an economic perspective.”

Bastasic is running a 70-name fund, which has an average duration of 3.85 years. He also aims for an average credit rating of BB, one step below investment-grade. Over the past year, he has moved away from a defensive stance, and gradually shifted into lower-quality bonds. There is 27% foreign content, although much of that exposure is hedged back into C$.

A value-oriented investor, Bastasic favours bonds issued by real estate firms and trusts and the leisure-hospitality industries. In the former area, he likes Toys “R” Us Property Co.; its B+-rated 2015 bond is yielding 8.6%. A subsidiary of Toys “R” Us Inc., the firm owns and manages properties that are occupied by the retail giant. Says Bastasic: “The Toys “R” Us brand is getting better and consumer spending should improve, and there is significantly high asset value, because of the properties.”

Within the leisure sector, Bastasic likes Royal Caribbean Cruises Ltd., whose 2016 bond is BB-rated, and yields 8%: “The leisure sector got hit hard. But Royal Caribbean has a strong brand and we expect to see stronger booking patterns into 2010. There is a lot of value in the name. It has positive momentum.” IE