Why Everyone Is Piling into Junk Bonds

08/24/2012 10:25 am EST

Focus: BONDS

Rob Carrick

Columnist, The Globe and Mail

Odlum Brown fixed income strategist Hank Cunningham likes exchange traded funds as a way to get exposure to high-yield bonds (also known as junk bonds). Here are the details, writes Rob Carrick, reporter and columnist for The Globe and Mail.

We used to applaud when an investment category had a nice run higher. Now, we slap a label on it saying "overvalued."

That's the financial world we live in—after five years of market ups and downs, both investing pros and retail investors are hyper-sensitive about the risk of losing money.

These days, high-yield bonds are getting the treatment. They've become very popular with issuing companies, they've performed well in the past three years, and now there's concern about a pullback.

This is certainly not the time to leap into high-yield bonds for the first time, but that doesn't mean you shouldn't use a small amount to diversify your overall bond holdings.

"Like most things in the world right now, there are pluses and minuses for high-yield bonds," said Barry Allan, founding partner at Marret Asset Management, which manages $6 billion worth of bond portfolios. "I don't think the high-yield market has a large amount of upside from where we are today, but I don't think it has a large amount of downside, either."

High-yield bonds are also known as junk bonds because they're issued by companies that aren't financially sound enough to qualify for an investment-grade credit rating. Technically, a bond is considered to be high yield if it has a credit rating below BBB.

Lower credit ratings mean higher risk of default, but investors are compensated for this risk with returns that can be four or five times a ten-year Treasury bond. As good as that sounds, junk bond yields are actually close to record lows in the US market.

Bond yields move in the opposite direction of prices, so falling yields mean rising prices. This is what has led to concerns that high-yield bonds have peaked.

What could send high-yield bond prices lower? Rising interest rates are the biggest threat to bonds in general, but high-yield bonds are much more resistant than government bonds. For high yield, the main risk is a rash of defaults, or companies failing to pay interest and redeem on maturity.

In the US high-yield bond market, vastly larger than in Canada, the default rate as tracked by Standard & Poor's was 2.8% in July. That's up from 2% at the end of 2011, but still low in comparison to the historical default rate of about 4.5%. According to Fitch Ratings, the default rate hit 13.7% in 2009, when recession threatened the economy.

The rising trend for defaults should be limited to some extent by healthy corporate balance sheets. Companies have lots of cash on hand, and while debt levels are high, the cost of borrowing is modest thanks to low interest rates.

Another way to measure the value in junk bonds is to compare their yields to government bonds. The gap, or spread, between super-safe Treasury bonds and more speculative high-yield bonds has recently been around six percentage points, which compares to a historical average of about five points.

Long term, the default rate for high-yield bonds has been nearly the same as the spread between their yields and government bonds. With the spread at a much higher level than the default rate today, you might conclude that investors are stressing about risk, and that high-yield bonds are actually a bargain.

Allan undermines that argument by noting that the spread today is wide because government yields are at extreme lows to support the economy. With government bonds at more normal levels, high yield would look fairly valued and not like a bargain.

Allan isn't much worried about default risk because he doesn't see disaster ahead for the economy. But he is concerned about the risk of a country, whether it's Europe, the United States or Japan, defaulting on its government bonds.

"The risk in the world is that sovereign debt issues overwhelm everything else. In that environment, high yield is not going to be a safe haven." We know this to be so from the experience of 2008, when the emerging global financial crisis inflicted double-digit losses on high-yield bond funds and highlighted how much riskier they are than government bonds.

Despite his concerns, Allan sees a case for risk-tolerant investors to hold high-yield bonds for income. He suggests staying short term—less than five years—and sticking to bonds with higher credit ratings. He himself focuses on bonds rated BB and B and avoids CCC ratings, where most defaults happen.

Issuers of high-yield bonds in the Canadian marketplace right now include Sherritt International, rated BB (high) by DBRS, Bombardier (rated BB), and Yellow Media (rated CCC). Choosing among them is a challenge that even an expert like Hank Cunningham declines.

"The risk of failure goes up dramatically when you try to choose your own high-yield bonds," said Cunningham, fixed-income strategist at investment dealer Odlum Brown. "Canada, in particular, has a very limited selection of high-yield instruments."

His preferred alternative is to use an exchange-traded fund for exposure to high yield, and his favorite is the iShares US High Yield Bond Index Fund (XHY).

XHY is based on the iBoxx USD Liquid High Yield Index and offers a high level of diversification through its 650 or so holdings in all the major economic sectors. Cunningham noted that this ETF is trading near its 52-week high, which highlights the popularity of high-yield bonds right now.

Cunningham takes a conservative approach to working high-yield bonds into a portfolio. He suggests 5% of your bond holdings be allocated to these bonds and sets 10% as a ceiling.

As with the stock markets, the prime buying opportunity for high-yield bonds was in late 2008 or early 2009, at the worst of the financial crisis. High-yield bonds further resemble stocks in that they've rebounded massively and are no longer a bargain. So be careful with them.

Mind the warnings, don't over-indulge and take a diversified approach. That's actually the right approach for pretty much everything in the investment universe right now.

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