It’s Time to Sell High-Yield Bonds

by Daniel Putnam | March 25, 2014 6:00 am

It’s Time to Sell High-Yield Bonds

High-yield bonds have been an outstanding investment in recent years, but investors would do well to look forward, not back, when assessing the outlook for the asset class. At this point, the potential rewards are no longer compensating investors for the risk — a key consideration for those who own high-yield ETFs such as iShares iBoxx $ High Yield Corporate Bond ETF (HYG[1]) and SPDR Barclays High Yield Bond ETF (JNK[2]).

bond vintage It's Time to Sell High Yield BondsThe problem with high-yield bonds isn’t that they’re in danger of imminent collapse. In fact, all of the pillars of their strong performance in recent years remain in place: low defaults, slowly improving economic growth, supportive Fed policy, and investors’ healthy appetite for risk.

Instead, the issue is that the risks now outweigh the potential returns. Yields are now so low that investors simply aren’t getting paid enough to own high-yield bonds. According to the Federal Reserve Bank of St. Louis FRED database, the yield of BofA Merrill Lynch US High Yield Master II Effective Yield stood at 5.62%[3] at Friday’s close. Comparatively, the average yield since the start of 1998 has been 9.65%.

Keep in mind that the average is skewed somewhat by periods in which the yield was exceptionally high, most notably the 2008-2009 crisis period. Still, yields are on the very low end of the historical range, and not far from the all-time low of 5.26% registered on May 8-9 of last year.

The low level of absolute yields is reflected in yield spreads that are also trending near their all-time lows. The BofA high-yield index offered a yield advantage of just 3.26 percentage points[4] over comparable Treasuries at the end of last week, well below the long-term average of 5.90. The last time the yield spread was this low was July 2007, just before the initial stages of the financial crisis began to unfold.

Risks Rising as Spreads Fall

Given that the four pillars of performance mentioned above all remain in place, it’s perfectly reasonable to argue that the low yields and yield spreads are justified by fundamentals. At this point, however, the lack of a yield cushion means that any disruption in the fundamental story will be detrimental to performance.

Less obvious is the fact that the potential impact of such a disruption is rising — due to the heavy recent issuance of bonds with lower credit quality and weaker covenants. The result is a stealthy increase in the level of credit risk inherent in the asset class.

At the same time, low yields are creating a higher level of interest-rate risk than investors typically associate with high yield. With spreads where they are, the odds are increasing that any rise in Treasury yields will be accompanied by a corresponding increase in the yields on high-yield bonds.

Keep in mind, too, that lower yields also mean lower return potential. While high-yield bonds have delivered outstanding historical total returns, these numbers incorporate a higher level of income than investors will receive in the future. With yields currently about four percentage points below the long-term average, that’s a substantial chunk of performance investors are giving up right off the top, irrespective of any potential price depreciation that may occur.

The result is that the clock is ticking for high yield right now, and investors who are reaching out the risk curve to get the 4.5% to 5.0% yields currently available in the major ETFs are picking up the proverbial pennies in front of a freight train.

What’s the Alternative?

Paradoxically, one of the factors supporting high-yield bonds is the lack of attractive alternatives.

Investment-grade bonds offer little in the way of yield to offset interest-rate risk — Vanguard Total Bond Market ETF (BND[5]) is yielding just 2.2% — and emerging market bonds feature the same combination of high credit risk and low yields.

The lack of alternatives is a valid concern, since nobody wants to sit in cash when prices are rising, but it pays to maintain a focus on the risk-reward picture when it comes to high yield. What’s the benefit of taking a chance on meaningful downside for minimal total return potential? Use this year’s good start as an opportunity to cut back on high yield and wait for a better price.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Endnotes:
  1. HYG: http://studio-5.financialcontent.com/investplace/quote?Symbol=HYG
  2. JNK: http://studio-5.financialcontent.com/investplace/quote?Symbol=JNK
  3. stood at 5.62%: http://research.stlouisfed.org/fred2/series/BAMLH0A0HYM2EY
  4. 3.26 percentage points: http://research.stlouisfed.org/fred2/series/BAMLH0A0HYM2
  5. BND: http://studio-5.financialcontent.com/investplace/quote?Symbol=BND

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