High-Yield Bonds Come with a Dark Side

10/05/2010 2:37 pm EST

Focus: BONDS

Rob Carrick

Columnist, The Globe and Mail

Safety-seeking investors are taking on more risk these days, but theyre not buying stocks, says The Globe and Mail columnist Rob Carrick.

Today’s conservative investors hate stocks. What they love are bonds, although no one’s happy with those atrociously low bond yields.

And so, high-yield bond funds have become the new big thing in bond investing. A simple description for the uninitiated: much higher returns, much higher risk. Hey, isn’t that what the stock market’s all about?

High-yield bonds are issued by companies that are weak financially and present a higher risk of default than blue-chip companies or governments. Added judiciously to the holdings of an investor who understands the risks, high-yield bond funds are a totally valid and effective tool for generating returns that right now can run to 6 or 7 percent.

But you have to wonder whether the dark side of high yield is being overlooked at a time when investors are fixating on income-paying investments of all types.

“Everyone’s asking about income,” Oliver McMahon, director of product management for iShares ETFs at BlackRock Canada, said this week as his firm launched a new exchange traded fund containing high-yield bonds.

RBC Asset Management announced the upcoming launch of a high-yield mutual fund this week at the same time as it announced its Phillips, Hager & North High Yield Bond Fund (CA: PHN280) would close to new money on November 26. The PH&N fund is basically too popular—sterling results are drawing in more money than the managers can comfortably handle.

“Rather than buying traditional bond funds, people are increasingly looking at higher-yielding bond products as a way to diversify their fixed-income holdings,” said Jonathan Hartman, vice-president of investment products at RBC Global Asset Management.

High-yield bonds, sometimes known as junk bonds, have been around for decades but never achieved fad status. That may be happening today as yield-hungry investors have prompted record bond issuance by companies with lower-tier credit ratings. Data from CIBC World Markets show that $2.5-billion in high-yield bonds has been sold this year, compared with $1.2-billion last year, virtually zero in 2008 and $425-million in 2007.

More bonds have meant more high-yield mutual funds and exchange traded funds for investors. The number of high-yield mutual fund choices has increased by 32 percent in the past 12 months—to 143 from 108. In the ETF world, the BMO, Claymore and iShares families have each launched at least one product devoted to high-yield bonds in the past year or so, and there are also hybrid products like the iShares DEX HYBrid Bond Index Fund (TSX: XHB) unveiled this week.

This fund tracks an index of Canadian bonds that is 82-percent weighted to investment-grade corporates with a triple-B rating and 18-per-cent weighted to high yield. Most high yield funds rely mainly on the US market because it’s much bigger and thus easy to trade in and out of bonds at competitive prices. A move into Canadian high yield raises the question of whether our comparatively tiny, illiquid market will exact a performance penalty on XHB.

“We have no concerns whatsoever about this,” said BlackRock’s Mr. McMahon. “The high-yield market in Canada is relatively small, but it’s growing very quickly.”

The bond fund managers at Canso Investment Counsel have taken a look at the new high-yield bonds coming to market and they’re not much impressed. One complaint is how low bondholders rank among creditors in case of a bankruptcy.

“There’s a lot of high yield lately that is very risky, very badly structured,” said Heather Mason-Wood, a Canso vice-president.

Her colleague, Richard Usher-Jones, came up with this vivid characterization of high yield as a market niche where demand from investors has resulted in lower-quality securities: “High yield is the new income trust market.”

High-yield bonds can easily double the 2- or 3-per-cent yield available from bonds issued by Ottawa and the provinces, and they’re much more resistant to rising interest rates than government bonds. This is a key argument for having as much as 5 to 10 percent of your total portfolio in high yield.

Mind the default risks, though. Bond rater DBRS lists AbitibiBowater, Nortel Networks, Quebecor World, and Tembec among the companies that have defaulted on their bonds in the past couple of years. You don’t just lose out on interest if a bond defaults—the price of the bond plunges as well, potentially all the way to zero.

Also, high-yield bonds are a lot more volatile than regular bonds. In fact, their ups and downs resemble stocks more closely than government bonds. In 2008, amid the worst conditions imaginable, high-yield bond funds lost 15.3 percent on average and some big players lost between 20 and 40 percent. In fact, a big reason for the strong performance of high-yield bond funds in the past year or so is a rebound from those lows.

Want something less volatile? You get a smoother ride, but also lower yields, from investment-grade corporate bonds. These are bonds issued by strong companies with credit ratings that range from the top rungs on down to triple-B.

BlackRock’s experience this year suggests it’s high yield that investors want. Assets in the iShares All Corporate Bond Index Fund (CA: XCB), an investment-grade corporate fund, have fallen a bit this year, while a high-yield fund introduced early in 2010 has zoomed all the way from $4-million in assets to $152-million.

Have some high-yield buyers been lulled into a false sense of security by the fact that they’re buying bonds? That’s what worries Jim Steel, president and portfolio manager with Polaris Financial in Ottawa. “My view is that high-yield bond funds are really just equities in disguise.”

HIGH YIELD IN HIGH GEAR

Here’s a summary of some mutual funds and exchange traded funds that provide exposure to high yield bonds. They’ve all been launched in the past 12 months, with the exception of RBC High Yield Bond, which will open October 12.

Mutual funds (and what they invest in):

PowerShares High Yield Corp Bond Index A (US high yield bonds)

RBC High Yield Bond (High-yield bonds issued by Canadian and US companies)

Sentry Tactical Bond (A mix of investment grade and high-yield corporate and government bonds)

Sprott Diversified Yield (Bonds issued globally by both corporations and governments)

ETFs (and what they invest in):

BMO High Yield US Corporate Bond (ZHY) (US high yield bonds)

BMO Emerging Markets Bond (ZEF) (High-yield and investment grade government bonds)

Claymore Advantaged High-Yield Bond (CHB) (US high yield bonds; pays tax-advantaged income)

iShares DEX HYBrid Bond Index Fund (XHB(Mainly triple-B rated corporate bonds and some high-yield bonds, all in the Canadian market)

iShares US High Yield Bond Index Fund (XHY) (US high yield bonds)

Rob Carrick

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