Outlook cloudy for high-yield bonds

Gambino shares portfolio-management duties with Jane Lesslie, an emerging-markets bond specialist and senior portfolio manager with London-based RBC Asset Management (U.K.) Ltd.

Gambino notes that the high-yield sector benefited last year from the dissipation of so-called “tail risks,” such as worries about the European sovereign-debt crisis and an economic slowdown in China: “Rightly or wrongly, the market priced in less tail risk, from a macroeconomic perspective. At the same time, in the past four years, the corporate sector has strengthened its balance sheet and increased its financial flexibility.”

High-yield bond funds, he adds, have seen “record inflows” from investors looking for higher yields.

Still, Gambino says, there could be headwinds this year in the form of stretched valuations. On average, high-yield bonds are trading at about $104, which indicates that they are expensive. “Yields are at record lows of about 6%,” he says, referring to the yield of the benchmark Bank of America Merrill Lynch high-yield master II index. “The fundamentals are very strong and default prospects will be muted. Spreads are still pretty generous, about 520 basis points [bps] over comparable U.S. treasuries. But given where they trade today, the average high-yield bond should deliver a more moderate return going forward.”

The RBC fund’s benchmark is a 50/50 blend of high-yield and emerging-markets bonds. Gambino and Lesslie favour the high-yield sector, which accounts for about 49.2% of the RBC fund’s assets under management (AUM), followed by 44.7% in emerging-markets sovereign bonds, 4.6% in emerging-markets corporate bonds plus 1.5% in cash.

On average, the credit rating for the fund is BB-plus. The fund’s duration is 5.1 years, vs 6.06 years for a blended benchmark (Bank of America Merrill Lynch index and J.P. Morgan emerging markets bond index). “It’s less a quality issue, on the emerging-markets side,” says Lesslie. “The credit curve is very flat in many of these countries. To be going out in the Philippines to 2037, for example, from 2022, you’re only getting an extra 15 bps. Relative to the spread duration risk, there’s not a lot of compensation.”

Running a diversified fund with about 310 holdings, the co-managers like high-yield bonds such as those issued by Videotron Inc., and its parent, Quebecor Media Inc. “They have very strong franchise values and have very strong operational momentum,” says Gambino, noting the Videotron bond, maturing in 2021, is yielding about 4.5%.

On the emerging-markets side, Lesslie has overweighted sovereign bonds issued by Turkey, Mexico, Russia and Peru.

Barry Allan, president and CEO of Toronto-based Marret Asset Management Inc. and manager of Dynamic High Yield Bond Fund, admits he is adopting a neutral stance: “Shorter term, I am on the cautious side of neutral; but longer term, I am on the bullish side. The economic fundamentals, in terms of corporate balance sheets and the likelihood of low default rates, are strong. But the issue that leads me to be cautious is more related to the macro scenario and what can happen to the government-debt sector.”

Allan is concerned about the state of U.S. government finances and fearful that the U.S. will not truly address its fiscal situation but only push it out into the future. “They will do a deal, but it will be useless in terms of moving to a sustainably lower deficit,” says Allan, referring to so-called “debt ceiling” discussions in Washington, D.C.

If there is volatility in the fixed-income arena, Allan argues, spreads could widen in the high-yield sector, which could happen in the first half of 2013. Longer term, though, he is bullish because default rates are less than 2%, compared with the historical average of 4.5%.

Spreads are a little wider than the historical average of 500 bps, Allan says, adding: “But that’s only because government bond yields are so low. If bond yields were where they should be – say, 2.5%-3% – the spread would be 330 bps. From a yield standpoint, given the default characteristics, high yield is not cheap. The sector won’t be a haven if we get volatility. That’s why I am cautious in the next three to six months. But if there is a good correction, our long-term outlook will assert itself and we’ll spend our cash.”

Allan does not believe there is much room for yields to drop further unless there is a very positive resolution of the U.S. fiscal crisis: “I don’t think there is room for a massive sell-off. I just don’t think there is a lot of upside from a 6% yield.”

Consequently, he is cautious and expects returns of about 5% this year.

From a strategic viewpoint, Allan has adopted a barbell approach – about 75% of the Dynamic fund’s AUM is in shorter-duration, high-quality, highly liquid names that yield about 5% on average. The rest is in higher-risk resources names that tend to yield about 8%. “That sector is quite cheap,” he says, referring to energy and mining companies whose stocks have fallen because of fears of a slowdown in China. “We don’t buy into the hard landing.”

From a credit standpoint, Allan emphasizes quality. About 15% of AUM is in investment-grade bonds, followed by 35% in high-quality BB-rated bonds and 41% in better quality B-rated names, with the remainder in CCC or lower. There are about 130 bonds, from 75 issuers.

On the resources side, Allan likes Athabaska Oil Sands Corp., whose 2017-dated bond yields 7.35%. Within the core of the fund, Allan favours names such as MGM Resorts International Inc., which has a 2013-dated bond yielding 6.75%.

Although Derek Brown, vice president of Fiera Capital Corp. in Toronto and portfolio manager of Altamira High Yield Bond Fund, expected a temporary remedy to the U.S. “fiscal cliff,” he argues that it could take the year to arrive at a lasting solution for the debt ceiling: “They will spend the rest of 2013 working on a big, long-term solution, such as the one proposed by senators Simpson and Bowles. Obama will push for that.”

Brown expects that U.S. economic growth could be “pretty good” in 2013 and high-yield bonds should do well. “There won’t be equities-like returns,” he says, “such as we saw in the past couple of years, but returns will still be good – around 8%-10%, before fees.”

If interest rates do go up, he adds, high-yield bonds will be less affected by changes to 10-year government bonds, mainly because high-yield bonds tend to have shorter durations. “We are pricing in a very gradual increase at the longer end, pushing the 10-year bond yield to 2.2%, or about 50 bps, over the course of the year,” says Brown, adding that the high-yield bond market should benefit as investors shift away from investment-grade bonds that will be affected more by rising rates.

Although sectors such as financials have seen yields fall considerably, less favoured sectors, such as energy and gaming, are ripe for further declines in yields.

Brown has gradually raised bond quality. About 41% of the Altamira fund’s AUM is in B-rated bonds, 34% in BB-rated securities, 10% in BBB-rated bonds, 10% in CCC-rated, and 5% in cash. About 65% of the picks are driven by credit selection, with the 35% based on tactical decisions. The fund’s 70% exposure to U.S. securities is hedged back into the Canadian dollar.

Brown is reducing the Altamira fund’s portfolio of 110 issues to about 70 to 90 issues. One favoured name is Heckmann Corp., a U.S.-based oil-service firm that provides so-called “fracking” liquids and transportation equipment to senior exploration firms. “[Heckmann is] in the Bakken area that straddles Saskatchewan and North Dakota, and [has] very big, stable contracts,” says Brown. The April 2018-dated bond, which has a B-minus rating, is yielding about 9.8%.

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