HIGH-YIELD (A.K.A. “JUNK”) bonds have become stars in the bond market, as they’re delivering returns far higher than what government bonds and investment-grade corporate bonds generate in the present environment of low interest rates. And with the default rate down to low single digits, junk bonds are looking like a better investment for your clients than this asset class has since just prior to the financial crisis of 2008-09.
Returns in the junk-bond market, which is composed almost entirely of U.S. issues, have been spectacular this year. The bellwether Bank of America Merrill Lynch master II high-yield index produced a return of 8.8% for the 12 months ended Oct. 31.
For example, a Sprint Corp. 7.875% bond maturing on Sept. 15, 2023, which was issued at par of US$100 this past September, rose swiftly to US$108. Rated BBB-low by Standard & Poor’s Financial Services LLP (S&P) and B-high by Moody’s Investors Service Inc., this US$4.5-billion issue offers a good yield, a good name and ample liquidity. It’s junk that you could call high-end and high-yield. But this issue is not alone, for subinvestment-grade debt is trading in a bull market.
Three factors have come together to boost the market’s appetite for high-yield debt:
– Persistent low interest rates and the U.S. Federal Reserve Board’s evident reluctance to begin tapering its US$85-billion-a-month monetary stimulus program has driven bond investors who want a return that beats inflation and then adds some compensation for risk to take chances with default.
– Reviving prospects for the U.S. and the global economy have driven down the default rate.
– There’s a new realization that junk may not be so “junky” when compared with government bonds, which, if they default, will do so slowly by failing to keep up with inflation rather than suddenly in their issuers’ inability to pay.
“Negative real returns on short-term government bonds push investors into the high-yield market,” explains Adrian Prenc, vice president and portfolio manager with Toronto-based Marret Asset Management Inc., which specializes in the junk bond market. “The fundamental argument for high yield, which is enhanced returns, remains sound because default rates remain low.”
In fact, as of Sept. 30, 2.6% of outstanding high-yield bonds had defaulted on a yearly basis, according to a report by Moody’s, which adds that the annualized default rate for speculative-grade debt is expected to rise to 3.2% by the end of the year. Even so, these rates are well below the historical average of 4.8%, a rate that has been tracked since 1983. Adds Barry Allan, Marret’s president: “We expect the default rate to fall slightly toward 2% in 2014.”
For your clients, the question now is whether to buy or sell. With current index pricing, junk has a 6.42% yield to maturity, on average. That’s a sizable 443 basis point (bps) spread over the index of comparable U.S. treasuries. The yield on junk offers good value and is still attractive for investment, Prenc says. The historical spread range is 270 bps (reached in 2007) to 2,200 bps (reached in early 2008, when defaults soared to 14% of outstanding junk).
Today, with many high-yield issues selling above their redemption prices, there’s trading risk on top of default risk. Some junk bonds have call options that make them redeemable at the issuer’s choice if the bonds reach a given price. Redemption means the bondholder loses any upside on the bonds above the call price. But if things go badly for the issuer, the bonds can tumble in value to the C-grade level (at which default is contemplated by credit-rating agencies and bonds are priced accordingly) from being merely subinvestment-grade at a B-level credit rating. This means that while the upside is limited, the downside is not.
What’s next is the question. When interest rates begin to rise, presumably because unemployment has fallen to the Fed’s target level and inflation has increased, government bonds will lose value, perhaps dramatically. Improving business conditions will tend to strengthen businesses’ balance sheets and income statements, potentially driving up the value of all corporate bonds – and especially subinvestment-grade debt that issuers will find easier to service. But government bonds, which trade on interest rate and duration risks alone, will suffer.
“You don’t want to be holding government bonds when interest rates are rising,” says Alan, who adds that junk is a good place to be for now, as well as a good place to stay until interest rate rises have forced down the prices of investment-grade bonds to a floor from which they can ascend in the next “down cycle” of interest rates.
Buying high-yield bonds isn’t easy. Issues may be lightly traded. For the purpose of risk diversification, you should recommend to your clients that they hold several issues, the number of which varies with the average credit rating of the issues and the terms, as defaults tend to rise over time. Thus, investing through mutual funds or exchange-traded funds offers your clients liquidity, diversification and, in the case of mutual funds, active portfolio management.
“Junk bonds are a play on credit risk,” says Graeme Egan, portfolio manager and financial planner with KCM Wealth Management Inc. in Vancouver. “That seems low right now, so money has moved to high-yield, pricing up the sector.”
And now, with everyone clamouring for yield, junk bonds look attractive.
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