High Yield Havens

03/15/2017 7:00 am EST

Focus: FUNDS

Mark Salzinger

Editor and Publisher, The No-Load Fund Investor

Despite a reputation for volatility, the high-yield bond market could prove safer than higher-quality bonds over the next year or two, explains fund expert Mark Salzinger, editor of The No-Load Fund Investor.

Though increases in economic growth, inflation and Treasury yields are likely to cause price declines among high-quality bonds in 2016, prices of high-yield bonds are likely to be more resilient, for several reasons.

One, the same economic factors that are likely to hurt the prices of high-quality bonds should benefit the high-yield market. A stronger economy should improve the cash flows and credit quality of high-yield issuers, which would allow for a continued shrinking in yield spread between high-quality and high yield.

Two, with prices having rebounded somewhat and now stabilizing for many commodities, the financial situations for natural resources companies - the source of more than 80% of all high-yield defaults in 2016-have improved to the point where defaults are likely to plummet in 2017.

And three, issuance of new high-yield debt has actually fallen considerably over the past several years, from a multiyear high of $332 billion in 2012 to a more moderate (though still above average historically) $237 billion in 2016, according to the Securities Industry and Financial Markets Association, a trade group for the financial services industry.

Without a substantial overhang of new supply in the high-yield market, continued demand for higher-yielding securities should support prices at least near current levels.

One of our favorite high-yield investments is PowerShares Fundamental High Yield Corporate Bond (PHB), which is on the higher-quality side of the high-yield corporate bond universe.

An index fund, instead of weighting its holdings by total issuance, it does so by the importance of the issuer in the economy, as measured by fundamental factors including the value of assets and the amounts of sales and cash flows.

By doing so, it avoids large weightings in the lowest-quality, most heavily indebted companies. Over the past three years, PHB has achieved an annualized total return of 3.4%. It currently has an SEC yield of 3.9%.

Mutual fund investors may want to consider Vanguard High Yield Corporate (VWEHX) Because the fund's expense ratio is so low - only 0.23% - the managers do not need to reach far down in credit quality to achieve an above-average yield.

As a result, it too offers superior credit quality to that of most of its peers. The fund has achieved a 4.6% annualized return over the past three years (6.3% over the past 10), and offers an SEC yield of 4.8%.

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