High-yield bonds rallied last year, as yield spreads continued to narrow over government bonds. Although some managers of high-yield fixed-income mutual funds maintain the prospects for their funds are positive in 2011, they also caution that investors may have to temper their expectations.

“We’re not going to experience the kind of returns we saw in 2009 and 2010 — really very good years,” says Frank Gambino, vice president with Toronto-based RBC Global Asset Management Inc. and lead manager of RBC Global Corporate Bond Fund and co-manager of RBC Global High Yield Bond Fund. “Going into 2011, we expect very modest capital gains. It will be a coupon-clipping type of year. Returns could be about 7%-9%.”

Several factors favour this outlook. First, the market is supported by modest economic growth. Second, fundamentals, such as earnings and declining debt levels, are also improving. And third, Canadian high-yield bonds still offer yields of 6%-7% — almost double the yields of government bonds. Says Gambino: “Valuations seem very attractive relative to other fixed-income categories.”

Moreover, positive sentiment regarding the asset class has attracted significant cash inflows. “There’s been quite a bit of supply in the market,” he adds, “but that’s been met by strong demand.”

Investors have bought in because high-yield bonds provide a measure of protection should interest rates start to rise again, Gambino explains: “You are starting with a bigger coupon stream, which could absorb capital losses from rising rates. But as the economy improves, the credit spread over government bonds should continue to contract.”

Gambino says that the risk of a double-dip recession in the U.S. economy has dissipated. “A lot of positive indicators have come out in the past few months,” he says, noting that extension of the so-called “Bush tax cuts” will act as a fiscal stimulus. And although the sovereign debt crisis in Europe is affecting market sentiment, he adds, on the whole, the asset class is weathering that crisis.

RBC Global High Yield Fund, co-managed by Jane Lesslie, vice president at London-based RBC Global Asset Management (U.K.) Ltd., has a split benchmark: 50% Citigroup high-yield index and 50% J.P. Morgan emerging markets bond index. Currently, 44% of the fund’s assets under management is in emerging markets, 54% is in North American high-yield bonds and 2% is in cash. There are about 190 holdings, including bonds issued by Turkey, Indonesia and U.S. firms such as Ford Motor Credit Co.

RBC Global Corporate Bond Fund is benchmarked against six indices (dominated by the Barclays U.S. corporate bond C$ index). About 70% of the fund’s AUM is in U.S. and Canadian investment-grade bonds, 15% is in U.S. high-yield bonds, 10% is in emerging markets and 5% is in cash. The fund holds more than 450 securities, with larger holdings by issuers such as JPMorgan Chase & Co. On average the bonds are rated BBB- or better. Says Gambino: “We are using emerging markets and high-yield bonds to enhance the return potential of a fairly high-quality global corporate bond portfolio.

Although Investors Have reaped the rewards in the past year, buoyant market conditions have encouraged the issuance of many new bonds that require careful scrutiny, says Jean-Pierre D’Agnillo, vice president at Montreal-based Standard Life Investments Inc. and manager of Standard Life Corporate High Yield Bond Fund. “It has been a record year,” he says, noting that there were about $3.5 billion in new issues in Canada and US$261 billion in the U.S. in the 11 months ended Nov. 30, 2010.

“It has been one of the strongest years in Canada,” he says. “In the pursuit of higher-yielding assets, investors have embraced this type of product. Before 2009, there were a handful of Canadian issuers, which included companies [such as] Shaw Communications Inc. and Rogers Communications Inc. Now, they’ve been bumped up to investment-grade. Since then, more than a dozen new issuers have come to market in Canada.”

But D’Agnillo is concerned about the pricing of the new issues “The theme is the same: a lot of buyers and prices rallying on the break,” he says, referring to the way these bonds had rallied soon after being issued. “There has been a lot of demand. This has supported the market.”@page_break@Yet, investor interest has begun to wane slightly since Government of Canada bond yields started to climb in October (10-year bond yields have since moved to 3.17% from 2.75%). Says D’Agnillo: “Corporate bonds have the benefit of more yield, so that cushions the blow of principal loss if spreads rise.”

Currently, the benchmark DEX high yield index is yielding about 6.97%, which means there is a 460-basis-points spread over five-year Canadas.

D’Agnillo manages a portfolio in which the average credit rating must be BBB, which is higher than most competing funds. The Standard Life fund can hold some high-yield bonds, but he admits to being very picky. Currently, 60% of the fund’s AUM is in A-rated bonds or higher, 39% is in BBB and only 1% is in BB or lower.

“Every week, we see a new issue and do our homework,” says D’Agnillo. “It has to fit our expectation of pricing.” He has not bought some high-yield issues because of the nature of their businesses; others did not meet his pricing expectations. “We do the same thing for investment-grade bonds,” he adds.”It’s a twofold decision: if we like the credit, that’s one side, but if it’s too expensive vs comparables, we just won’t buy it.”

The Standard Life fund’s high-yield exposure has shrunk in the past year, largely because many bonds in the portfolio were upgraded in 2009. Meanwhile, D’Agnillo has been buying issues by firms such as Rogers, whose bonds are now investment-grade. From a sectoral standpoint, 24.6% of the Standard Life fund’s AUM is in banks, 18% is in media and telecommunications, and there are smaller holdings in areas such as energy, resources and infrastructure.

Running a 46-name fund, D’Agnillo added one issue early last year: Montreal-based cable operator Vidéotron Ltd., which issued a 10-year, BB-rated bond that now yields 6.25%. Says D’Agnillo: “We liked the business. It’s very well run. And it was issued in a period in which the market was taking off in Canada, so the pricing was more interesting than what is available now.”

The High-Yield Bond Asset class is between slightly cheap and fair value, says Terry Carr, vice president and managing director, fixed-income, with Toronto-based MFC Global Investment Management (Canada) and lead manager of Manulife Corporate Bond Fund. “But it still represents — given the opportunity of other asset classes, such as government bonds, investment-grade corporate bonds and equities — reasonable valuation and protection features with moderate upside potential on a spread basis.”

Carr, who shares management duties with MFC vice president Richard Kos, argues that the U.S. benchmark Bank of America Merrill Lynch high-yield master II index spread is about 600 bps over U.S. treasuries, or slightly above long-term averages of 550 bps. “With about 100 bps above long-term averages, and notwithstanding a weak economy, default rates are very low and trending lower. Something that yields about 7.8% (the U.S. benchmark yield) will have a strong place in a portfolio,” says Carr, who expects high-yield funds could return 5%-10% in 2011. “If things continue to improve from here, high-yield bonds will dramatically outperform government securities.”

Carr believes the economy is making slow progress while enduring bouts of pessimism and optimism. “Governments and central banks are doing the right thing,” says Carr, “and over time will win the battle. So, from an asset class allocation, you want to place your bets on things on the riskier side as opposed to the safest bets, government bonds. We adhere to this theme going forward, but do it in moderation.”

From a strategic viewpoint, about 56% of the Manulife fund’s AUM is in high-yield bonds (of which 40% is in U.S. securities that are protected by a currency hedge) and 44% is in investment-grade bonds that are mainly Canadian. The maximum allowed is 66% in either asset class. Says Carr: “Are we erring on the side of extreme caution, or modest risk? We’re taking a modest risk and are slightly overweight [in] high-yield.”

During the winter rally, the Manulife fund sold some lower-rated bonds and took profits, says Carr: “We’re taking things that were way overpriced out of our high-yield mix, but are trying to find other good opportunities to invest in.”

Running a portfolio of about 100 high-yield names and 100 investment-grade firms, last autumn the Manulife fund acquired an unrated bond of customs broker Livingston International Inc. yielding about 8.7%. Says Kos: “We [saw] a tested business model and there’s a lot of opportunity for growth.” IE