At a time of ridiculously low interest rates, some income-starved investors have been drawn to high-yield bonds, a risky but often misunderstood asset class that can add a bit of stability as well as punch to a portfolio.
High-yield — often called junk — bonds paid about 8.34 percentage points more than United States Treasury issues of comparable maturity, on average, on Sept. 30. Although that is well under the double-digit point premiums that prevailed at market bottoms during the last decade, specialists say that this may still be a profitable time to consider high-yield mutual funds, which are particularly appropriate for tax-sheltered accounts.
“I think the market is attractive,” said William J. Morgan, senior high-yield portfolio manager for J. P. Morgan Asset Management. Junk bonds were trading as if almost 9 percent of issues will default over the coming year, Mr. Morgan observed, even as Moody’s Investors Service projects that only 1 percent to 2 percent will do so.
“I see high-yield as offering pretty decent value here,” agreed Matt Eagan, co-manager of the Loomis Sayles Bond fund, which invests up to 35 percent of assets in lower-rated securities.
Mr. Eagan noted that despite weak economic growth, American companies are enjoying hefty profits, indicating that they cannot only handle interest and principal payments on their bonds but also can take advantage of today’s low interest rates should they need to refinance.
“The default rate is likely to remain low,” he said, and is quite unlikely to rise much above 5 percent even if the economy skids back into recession. Default rates peaked at more than 10 percent after the 2008 meltdown, in the early 2000s and in the early 1990s.
Investors who cringe at the idea of buying low-quality debt — the BBB rating is generally considered the border with investment-grade bonds — should recognize that it can act as a kind of stabilizing portfolio ballast, some specialists maintain.
“A certain mix of higher-quality and high-yield bonds lowers volatility while boosting and smoothing returns,” Mr. Morgan said.
Major companies, not just start-ups or fringe telecoms, are now among the biggest issuers of high-yield — the likes of Ford Motor Credit, the CIT Group, the Hospital Corporation of America, Ally Bank and Sprint Nextel.
Still, the market for high-yield bonds is highly volatile and subject to periodic bouts of illiquidity like the one that occurred in August. That is when the fund category, which had been posting double-digit returns during the preceding 12 months, suffered its biggest monthly loss — 4.37 percent — since 2008, according to Morningstar. (The high-yield market had a lesser skid in the second half of September.)
PRICES slumped after Standard & Poor’s, citing the political stalemate after a rancorous Congressional debt-ceiling debate, cut the United States’ credit rating. High-yield investors are very attuned to talk of defaults, but the market also suffered from the European financial turmoil and even the effects of the Japanese tsunami.
“The market had a mass anxiety attack, as all risk assets did,” said Mark Vaselkiv, manager of the T. Rowe Price High Yield fund.
The performance of high-yield bonds, unlike that of investment-grade issues, is very sensitive to the stock market and the economy. Good times indicate that borrowers have a greater ability to service debt, which is far more important to high-yield buyers than the rising interest rates that typically accompany faster growth and that depress the prices of better-quality bonds.
The risk of rising rates, in fact, is limited for high-yield bonds because they almost always come due in 5 to 10 years, compared with 30 years or more for most other corporate bonds. Moreover, their high interest rates provide a cushion against falling prices in a rate upswing. “High-yield will outperform when interest rates go up,” Mr. Morgan said.
Many specialists say the only sensible way for ordinary investors to buy high-yield debt is through mutual funds — both to obtain essential diversification and to avoid being victimized by wide gaps between buying and selling prices in a market that may have relatively little activity.
Retail investors in individual bonds are taking big risks, partly because of the likelihood of unfavorable execution of orders, Mr. Vaselkiv said.
Jeff Tjornehoj, a senior research analyst at Lipper, said that one excellent fund was Fidelity Capital and Income, because of consistent long-term performance, tax efficiency and annual expenses of a reasonable 0.76 percent. It returned 7 percent, annualized, in the five years through Sept. 30 but lost 10.8 percent in the quarter, according to Morningstar. Some 43 percent of its portfolio is in bonds rated B, and 12 percent are rated CCC or below; 17 percent of the fund is invested in stocks.
He said the Vanguard High-Yield Corporate fund has been a high-quality “middle of the road” performer with a portfolio averaging a B rating. It returned 3.7 percent in the quarter , while charging just 0.25 percent in expenses, according to Morningstar.
But there is substantial variation among the more than 500 high-yield funds, with some embracing bonds rated CCC or even lower, as well as common and preferred stocks, convertibles or even derivatives.
The unwary may find the junk market downright treacherous, Mr. Tjornehoj cautioned. “The investor must accept greater volatility and a real risk of loss,” he said, pointing to the Oppenheimer Champion Income fund, which lost about four-fifths of its value in 2008 because of heavy losses on credit default swaps and mortgage-backed securities.
Potential buyers should at least check a fund’s portfolio to make sure it isn’t committed to more low-quality risk than they want and isn’t overly concentrated in certain industries. Good credit analysis by fund managers should uncover issues that are candidates for a ratings upgrade.
Zane E. Brown, a fixed-income strategist at Lord Abbett, noted that gambling, leisure and automotive companies are frequent high-yield borrowers, which could lead to unbalanced fund portfolios if such companies are overrepresented. He now frowns on the bonds of home builders and companies in the paper, publishing and printing industries because, he says, their prospects are generally poor.
While defaults are the biggest hazard in the junk market, analysts also try to predict how much can be salvaged when they occur. The average recovery has run at 44 percent, Mr. Morgan said.
ALTHOUGH many high-yield managers include a wide variety of securities in their portfolios, Mr. Brown sticks closely to corporate bonds. He avoids foreign government bonds because they are harder to analyze and are subject to sudden political change.
Investors should beware of funds offering the very highest current returns, experts also said. Not only might their holdings be of very low quality, but the managers may be paying premium prices, thereby returning some principal in the guise of interest, Mr. Eagan said.
With these cautions, high-yield may be appealing these days — though not the screaming bargain it proved to be when market liquidity evaporated in 2008. But Mr. Vaselkiv issued a caveat: This market may be good “as long as we don’t go into a double-dip recession,” he said. “It’s really a bet on the U.S. economy.”