High-yield debt is soaring in value as investors shed their worries about defaults and buy into junk’s double-digit returns.
With the bullish sentiment that has driven the S&P/TSX composite index up by 42% over its March 9 low, high-yield bonds have soared in value. The most widely used indicator of the market, the Merrill Lynch master II high-yield index, has recently yielded 11.5%. That’s a huge comedown from the phenomenal 20% yield the index posted in December 2008.
High-yield bonds are trading in their normal range, explains Chris Horoyski, senior vice president and fixed-income portfolio manager with Aurion Capital Management Inc. in Toronto. “Yields are now where they were at the peak of the recessions of 1991 and the credit spike of 1982,” she explains. But the extraordinary gains could be overdone.
The return to what seems like normalcy is not quite complete, however. High-yield bonds continue to reflect declining credit quality. Thus, the high-yield market is caught between the expectation of rising defaults and what the market sees as the reality of improving business conditions. Closing the spread gap and bringing junk yields down to a more normal level of 500 basis points to 800 bps over Treasuries will not happen, Horoyski notes, until the recovery is a matter of fact rather than prediction.
For now, bond investors’ essential question is whether to buy high-yield debt and capture what is seen as the eventual closing of the gap, getting handsome interest and waiting for the high-yield price to appreciate further. The alternative is to stick with investment-grade debt and not worry about serious probabilities of default. If the global recovery does not pan out as expected, then the junk bond recovery is likely to falter as well.
Looking beyond the recovery, conventional corporate bonds have tended to produce solid returns. For the 10 years ended June 30, the Salomon Bros. corporate bond index has returned 6.9% a year, compounded annually in U.S. dollars. However, the return in Canadian dollars is only 4.4%. The DEX corporate bond index of Canadian debt turned in a 6.5% return in the same period. Over the same period, high-yield bonds have returned 3.2%.
In comparison, in the same 10- year period, Canadian real-return bonds have produced an average compound return of 6.5%. Clearly, the winning bet has been on investment-grade corporate bonds.
The question tugging at the high-yield market right now is how high a price investors will pay to get in on the anticipated global economic recovery. Junk’s performance has already been astonishing, given that the recession continues — even though it may be moderating. Some managers think the runup in prices is played out.
Chris Kresic, senior vice president and head of fixed-income for Toronto-based Mackenzie Financial Corp. , says it is getting to be time to take profits on the high-yield bond recovery: “There is a lot of money going into this asset class. That is when you do not find many bargains. Spreads are going to shrink, but I don’t think we will get down as low as the 250 bps to 300 bps at which the master II high-yield index stood [when it was] at record lows.”
Which way to turn in the present recovery depends on your client’s taste for risk. As a fringe investment-grade credit, the Alcoa Inc. 6.75% US$ issue due Jan. 15, 2028, has recently been priced at $82.50 to yield 9% to maturity. It is rated BBB by New York-based Standard & Poor’s Corp. A US$2.24 per share loss for the 12 months ended June 30 is cause for concern. A strong global recovery would help eliminate the loss. For now, the 9% yield to maturity makes it a fairly low-risk bond at the border of the high-yield category, Horoyski says.
Trading down to the mainstream high-yield market, Bombardier Inc.’s 7.25% issue, due Dec. 22, 2026, recently traded at $76 to yield 10.3% to maturity; it has the advantage of being priced in Canadian dollars.
Bombardier presents no currency risk, but it is at the top of the airline business food chain. If a few of its big airline customers were to file for bankruptcy, Bombardier’s order book would suffer. Bombardier’s common shares are trading at less than half of their 2008 high. The bond market has tagged the bonds as chancy, and the issue carries a BB (subinvestment-grade) rating from S&P.
@page_break@Finally, a U.S. Airways convertible 7.25% bond maturing May 15, 2014, has recently been priced at US$85 to yield 11.40%. Depending on the rating agency, the bonds are rated between CCC and C, which is perilous territory and indicative of potential default. A prolonged delay in the economic recovery or soaring fuel prices could hammer the stock, recently priced at US$2.73 to reflect massive losses for the 12 months ended June 30.
Thus, the bottom-line question is: Are high-yield bonds worth the risk? CIBC Wood Gundy analyst Kory Brewster notes in the Monthly World Markets Report, published in August, that the cumulative probability of default for six years is 7.8% for AAA bonds, 15.5% for A- bonds, and 22.8% for bonds with the BBB- rating — the lowest investment-grade rating.
Diversification is the key to investing in subinvestment-grade debt. As risk rises, the need to diversify grows. Thus, a Government of Canada 4.25% issue due June 1, 2015, recently priced to yield 2.94% to maturity with an AAA rating, needs no company for an investor who wants a six-year federal bond.
The Canadian Tire Corp. 34.95% issue due June 1, 2015, recently priced to yield 4.57% to maturity, carries a BBB+ rating. A client with the same time horizon that holds this bond would not need more than a handful of similar bonds. But the client who elects to put money into a BBB- issue from YPG Holdings Inc.’s 7.3% issue due Feb. 15, 2015, recently priced to yield 7.32% to maturity, ought to diversify aggressively.
To offset the cost of diversification, your clients can use professional management in the form of mutual funds. High-yield mutual funds charge a median management fee of 2.1%.
For clients who prefer return more than adventure, taking on a great deal of default risk is a tough game to win. Over time, the default rate rises. Short-term profit in high-yield bonds is cyclical; but over periods of 15 years, 28.3% of bonds with a B rating default.
Over the same period, 59.4% of bonds rated CCC default, according to S&P data. This is one market in which the odds don’t favour the buy-and-hold investor.
IE
Trending into recovery: Junk bonds take flight
But investors need to stay nimble and keep a close eye on default risks
- By: Andrew Allentuck
- August 31, 2009 October 31, 2019
- 14:27