Squeezing More out of Bonds

12/05/2012 10:00 am EST

Focus: BONDS

Rob Carrick

Columnist, The Globe and Mail

Here are two options: High-yield and emerging-market bonds. Added with care to a portfolio, they can do good things, writes Rob Carrick, reporter and columnist for The Globe and Mail.

Good luck to you if you're waiting for rising interest rates to bump up your investment returns.

There's pretty much no evidence to support the case for rising rates in the year ahead. In fact, a forecasting firm called Capital Economics said this week that the next move in interest rates for the Bank of Canada is more likely to be down than up. That's a contrarian take, but it still reinforces the idea that rates will not rise anytime soon.

If you're looking to squeeze more out of bonds in a low-rate world, here are two options: High-yield bonds and emerging-market bonds.

"There's a good case to be made for long-term strategic allocation to a portfolio with these assets," said Greg Nott, chief investment officer of Russell Investments Canada. "They have very good risk-return characteristics."

High-yield bonds are issued by companies that aren't strong enough financially to qualify for what's known as an investment-grade credit rating. They're riskier investments than government or blue-chip companies, so they offer higher yields. Emerging-market bonds—issued by either countries or corporations—are similar in combining more risk and higher returns.

How much higher? A five-year Government of Canada bond yields about 1.3% these days, and five-year GICs top out around 2.25% to 2.8%. Nott said the Russell Global High Income Bond Pool, a fund product for retail investors that mixes high-yield and emerging-market bonds, has a yield of about 7% before fees. Depending on which series of the fund you buy, net yields come in around 5% or better.

If weighted properly, Nott says it makes sense to hold both types of bonds in the same portfolio. He suggests a combined weighting starting at 5% of a portfolio, and going no higher than 10% for risk-tolerant investors.

Don't clear out space for these bonds strictly by ejecting low-yielding but safe government and blue-chip corporate bonds. Nott said Russell's research has found that emerging-market and high-yield bonds work best when you allocate some to the stock side of your portfolio and some to the bond side.

The background here is that unlike government bonds, high-yield and emerging-market bonds will not provide a refuge when the stock markets plunge. The question in a fast-falling stock market is not whether these types of bonds will fall in price, but by how much. Investors will put up with this higher level of volatility in exchange for the high yields.

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Now for the details in mixing high-yield and emerging-market bonds into your portfolio. For a 5% total weighting in these two categories, Nott suggests adding three percentage points to your stock holdings and two percentage points to bonds. "Doing this allowed us to reduce the expected volatility [of a portfolio], and even though we're lowering [the] equities [portion], still maintain the same respective returns."

Add high-yield and emerging-market bonds strictly to the bond side of a portfolio and you get the potential for higher returns, but also more volatility. Add them to the stocks side and you get both lower volatility and lower returns.

Neither high-yield nor emerging-market bonds are any sort of a bargain right now. Russell Global High Income Bond Pool A has a gain of 12.95% for the year to October 31, the biggest high-yield bond mutual funds are up 5% to 13%, and a pair of emerging-market bond funds are up in the area of 11%. Nott considers both categories to be fairly valued—neither cheap nor expensive.

An issue investors should be aware of with high-yield debt is that strong demand from investors has caused some deterioration in the quality of bonds. Covenants protecting investors if an issuer of high-yield bonds runs into financial trouble have softened in some cases, and financially weak companies are issuing bonds when in the past they might have been shunned in the market.

All of this argues for the instant diversification of a fund—ETF or mutual fund. ETFs have much lower fees and more transparency in terms of what they hold at any given time. But Nott said there are benefits to using actively managed funds for high-yield bonds as opposed to using index-tracking ETFs.

He said the most-followed high-yield indexes give the largest weighting to the most indebted companies. The bonds issued by these companies tend to do particularly well in good times for high yield, and in bad times they sell off sharply. The net result is a higher level of volatility than investors may find in actively managed bond funds, where managers can underweight the big names.

The current malaise in the economy is actually a plus for high-yield bonds, Nott said. High-yield bonds outperform government bonds and stocks when the economy is growing slowly; they rank behind corporate bonds and ahead of stocks in a weak economy; and they lag stocks and beat corporate bonds in a strong economy.

The financial underpinnings of emerging-market bonds are actually strong, especially compared with the developed world. Nott's data shows that Brazil, Mexico, Indonesia, and Russia beat the United States, Britain, and Canada in measures such as the unemployment rate and debt-to-GDP ratio. And yet ten-year government bond yields for these four emerging markets range from roughly 5.7% for Indonesia to 9.6% for Brazil.

Nott said these higher yields reflect the generalized aversion to risk that investors have shown since the financial crisis, as well as concerns over the way in which investors would be treated in case of a default.

Still, he believes there's room for emerging-market bond yields to fall, while developed-market bond yields rise in the years ahead. "Will they get equal? Probably not any time soon. But will there be a modest degree of convergence? We expect so."

Read more from The Globe and Mail here...

Emerging-markets and high-yield bonds are not bargain priced, and they're vulnerable to financial market upset. But if added with care to a portfolio, they can do good things. Give them some thought if you're waiting for rising interest rates to bump up your returns and can handle a little risk.

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