Chasing High-Yield Bonds? First, Take a Breath

Investors in high-yield bonds have been handsomely rewarded in recent years, as a nearly ideal environment of low rates, slow growth and improving corporate performance has propelled the asset class to a huge return advantage over both stocks and investment-grade bonds.

Credit Suisse High Yield Index 7.71% 14.40% 8.80% 10.27%
S&P 500 Index 9.13% 14.13% 1.13% 6.34%
Barclays U.S. Aggregate Bond Index 7.25% 6.85% 6.91% 5.65%

Looking back further, the track record for high yield is even more impressive. According to data compiled by Peritus Asset Management — a California-based shop that runs the actively managed Peritus High Yield ETF (NYSE:HYLD) — the Credit Suisse Index not only provided returns in line with the S&P 500 in the 31-year period from 1980-2011 (10.60% vs. 11.05%), but it did so with a much lower level of risk (an annual standard deviation of 9.66% compared with 17.49% for the S&P 500). The results are even better compared to small caps, against which high yield delivered a better return with less than half of the volatility.

In short, high yield has provided investors with a much bigger bang for their risk “buck” than an investment in stocks in the past 30-plus years.

Does this mean investors should blindly buy high-yield bond ETFs such as SPDR Barclays Capital High Yield Bond ETF (NYSE:JNK) and iShares iBoxx $ High Yield Corporate Bond Fund (NYSE:HYG) right now? Not necessarily. Although there still is much to recommend an investment in the asset class, there also are reasons for caution. Below is a look at the pros and cons of investing in high-yield bonds at the moment:

The Pros

  • Yield spreads are reasonable: By one of the most important metrics for evaluating high-yield bonds — yield spreads — the asset class isn’t particularly expensive at this point. The chart below shows that the current spread over Treasuries, at 5.91 percentage points, is at about the midpoint of historical levels and about a percentage point higher than its low of early 2011. This indicates there is room for further yield compression without violating historical norms.

  • The default rate is low: The most recent report from Fitch Ratings showed a 12-month trailing default rate of 2.2%, which is well below the historical average of about 4%. Although declining revenues are beginning to hit profit margins for high-yield companies, years of cost-cutting and improved fiscal management have resulted in firm credit fundamentals for high-yield issuers.

  • The continued thirst for yield: With yields on Treasuries and other high-rated investments at exceptionally low levels, there is little to change the structural demand for higher-yielding assets aside from periodic increases in investor risk aversion. JPMorgan said it best in a recent research note, as reported by Barrons: “With global economic indicators continuing to soften and central bank policy action in motion, this Goldilocks scenario for high yield (an economy growing 1-2%, not too soft as to raise the risk of a recession and not fast enough to allow interest rates to rise), continues to reinforce the compelling relative case for investing in the asset class.”
  • Low interest rate exposure: One of the benefits of higher-yielding securities is that they have a much lower sensitivity to interest rates. The table below, from an Alliance Bernstein white paper, illustrates how securities with a 5-percentage-point yield advantage over Treasuries tend to have lower rate exposure — a plus if Treasury yields start to rise moderately.

The Cons

  • The easy gains might already be in the books: This blog post, which appeared in Barron’s Income Investing blog earlier in the week, effectively summarizes the largest problem with high yield right now. The key point is a quote from a Bank of America Merrill Lynch analyst, who stated: “At current levels, (high yield) is standing only 20 (basis points) away from its all-time historical low yield of 6.7%, and its premium price of 102.1 pts leaves today’s buyers with little hope for price appreciation.” The $102.10 number refers to the average price of a high-yield bond, as compared to the par value of $100. Since bonds need to trade down to par at maturity, this indicates a market that is stretched to the point where further price gains will be difficult to achieve.
  • Vanguard warns about froth: This is old news by now, but it’s still instructive. In late May, Vanguard closed its High Yield Corporate Fund because of massive inflows. In its press release, Vanguard’s CEO William McNabb stated, “In this prolonged low-rate environment, we continue to see investors turn to high-yielding alternatives — including money market fund holders moving to bond funds, U.S. Treasury bond fund holders moving to high-yield corporate funds, and bond fund holders moving to dividend-paying stock funds. And we’ve cautioned investors accordingly about reaching for yield.” When Vanguard feels the need to issue such warnings — and restrict inflows in the process — investors should pay attention. Indeed, the inflows into high-yield mutual funds so far this year exceed the total reached in all of 2011.
  • When the VIX is low, it’s time to go: Ultimately, the key determinant of high-yield bonds’ short-term performance results is investors’ attitude toward risk. This is illustrated by the nearly perfect negative correlation of -0.93 between JNK and the CBOE Volatility Index (VIX) in the past year. Keeping in mind that -1.0 indicates a perfect inverse relationship; this shows that a rising VIX almost always will result in lower prices for high-yield bonds. With the VIX currently in the mid-teens — deep on the low end of its five-year range — the odds are high that a decline in investor risk appetites is in the offing sooner rather than later.

The Verdict

When all of these factors are taken into account, it seems that the best approach is to wait for the opportunity to get into high yield at a better price. Although the asset class has an outstanding long-term track record, the current risk/reward profile indicates that investors should be well served by exercising a measure of patience.

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

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