Watch Out for the Froth in the High-Yield Bond Rally

Two-thousand-and-twelve has been an exceptional year for below-investment grade bonds as investors sought higher returns in a record-low interest rate environment. The Barclays High-Yield Bond Index—a proxy for high-yields—posted a 12.09% return for the first nine months of the year, compared to a 3.53% return for

the Barclays Intermediate Government/ Credit Bond Fund over the same period.

Although some investors call them “junk bonds,” BWFA has long regarded high-yield bonds as a respectable and worthwhile sector of the investment universe. They offer returns similar to common stocks and pay higher interest rates to make up for the higher risk of default. But unlike owners of stocks, holders of high-yield bonds generally have a claim against company assets in bankruptcy, while stockholders could lose everything. In many cases, this provides some downside protection compared to common stocks.

As of December 1, 2012, we held clients’ assets in seven high-yield bond funds. The percentage of each client’s portfolio held in those funds was based on his or her individual profile and needs. Within each fund, some bonds are safer (have a higher credit rating) than others. As we will explain below, we believe that now is a good time to review both the returns and the safety of the bonds in each fund.

Bond Fund Trends

Two factors have led to a surge in prices for high-yield bonds in the last few years. First, as the economy gradually improved, the chance of default or bankruptcy dropped for many companies; bonds that were seen as risky in the past now are safer. Second, The Federal Reserve pushed interest rates to historic lows to stimulate economic growth. Conservative investors found that the safest investments, such as CDs, Treasury bonds, and investment-grade corporate bonds, did not pay enough interest to save or pay for retirement. They looked at high-yield bonds as an alternative.

The impact has been startling. From January 1 through October 31, 2012, investors plowed a record $49 billion into high-yield bond mutual funds and exchange-traded funds, more than twice as much as the previous record of $21 billion, set in 2009. This helped to create outsized returns compared to investment-grade corporate bonds and Treasuries.

Another effect has been on the companies that issue the bonds. With greater demand for high-yield bonds, companies with less-than-stellar credit ratings have found it easier to issue bonds. By the middle of October 2012, they had shattered the previous annual record with $249 billion of new issues.

However, when the going is good, Wall Street often goes a step too far. That might be occurring right now in high-yields. In the first wave, companies floating these bonds used the proceeds to expand their businesses or to refinance debt with better terms. But that’s changing. More recently, we’ve seen companies like Petco, a leading pet specialty retailer, issue debt simply to make dividend payments to its private equity shareholders. This maneuver saddled the company with additional debt and, we think, left it in a weaker position.

Companies locked out of the bond market a year ago because they were perceived as too risky now have an eager audience, even though their financial condition has not improved. These changes have led to a decline in the average credit rating on high-yield bonds to C, near the bottom of the rating range (a BB rating is usually the top of the high-yield sector).

At BWFA we do not think these signs of excess mean it’s time to liquidate all high-yield bond funds. While we have reduced our exposure, we believe there is still opportunity to find good value in the cleaner end of the non-investment grade spectrum. We’re sticking with best-of-breed mutual funds that have a track record of navigating through strong and weak markets with a disciplined approach that maximizes risk-adjusted returns. We believe that a bias towards quality generally will result in keeping investors in a safer place at this time.

By Rob Williams  |  CFP