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High-yield bond funds: Love them or leave them?

Published:Wednesday | June 3, 2015 | 6:00 AM

Don't know what to make of the junk-bond market? Join the club.

One month, dollars are flooding into junk-bond mutual funds and exchange-traded funds. The next, dollars are pouring out the opposite direction.

Consternation is nothing new for this part of the market: Junk bonds are essentially loans made to companies with poor credit ratings, and they have to offer relatively big yields to attract investors. But skittishness has been particularly high, with US$9.3 billion fleeing junk-bond funds in December, only for US$9.6 billion to go right back in two months later.

Since then, flows have continued to be erratic into and out of junk-bond funds, which are also called high-yield bond funds, and several factors worry investors. The biggest is the threat of rising interest rates, which would knock down the price of all kinds of bonds.

Crude price scare

Last year's plummet in the price of crude was also a big scare because oil producers make up a big part of the

high-yield market. In addition, sceptics are warning about the high number of "tourists" in junk- bond funds. These are investors who would otherwise put their money in investment-grade bonds but are desperate for higher yields, and they could quickly abandon junk bonds en masse.

Even with all the jitters, junk bonds have produced better returns this year than most other parts of the bond market. The average high-yield bond mutual fund has posted a return of 3.7 per cent, versus one per cent for intermediate-term bond funds, the largest bond-fund category by assets.

If interest rates continue to rise gradually and if the

economy avoids a recession - and granted, those are significant ifs - many strategists say junk bonds can continue to

outperform the rest of the bond

market.

"Right now, you're getting paid for the risk of owning high-yield debt," says Jim Kochan, chief fixed-income strategist for Wells Fargo Funds Management. That hasn't always been the case, he says, citing periods when junk-bond yields weren't high enough to make up for their riskiness, such as before the Great Recession and last summer. "If the high-yield market gets too expensive, like it was in 2007 and in June of 2014, it's due for a correction. But it's not that expensive now."

To judge whether junk bonds are expensive, one factor to consider is how much more interest they pay over high-quality bonds. Yields for junk bonds are generally around six per cent today. That's not as much as they have been historically, but strategists say they're still comfortably above what high-quality bonds are paying. The 10-year US Treasury note has a yield of 2.1 per cent.

Because of that cushion, Kochan and others say high-yield bonds can better withstand a gradual rise in interest rates. It's a key question because the United States Federal Reserve is expected to raise its benchmark short-term interest rate from its record low later this year. Rising rates drag down prices of bonds that have already been issued because their yields suddenly look less attractive.

Prices for junk bonds would also fall as rates rose, but the increased income that they pay could help protect total returns. And given how wide the gap is between the yields of junk and investment-grade bonds, the cushion has room to shrink. If that were to happen, price drops could be less severe for junk bonds than for investment-grade bonds.

Defaults, another traditional fear for junk-bond investors, also look relatively benign for now. The default rate is below two per cent, as companies have refinanced their debt and earnings growth means they have enough cash to make good on their bond payments.

Many fund managers expect the default rate to tick higher as energy companies struggle with the lower price of crude oil. But unless a recession is imminent, they don't see the default rate jumping higher for other areas of the junk-bond market.

To be sure, if interest rates were to spike sharply and quickly or if the economy does fall into a recession, most everyone agrees junk bonds would suffer. And losses for junk bonds can be more swift and severe than for other areas of the bond market.

"High-yield acts like stocks in a recession," says James Swanson, chief investment strategist at MFS Investment Management. The average junk-bond mutual fund lost 26.4 per cent in 2008. That's closer to the 37 per cent loss for the S&P 500 index than the 5.2 per cent return for the investment-grade bonds.

If high-yield bond prices start to tumble, there's a concern that the market will become illiquid - meaning fund managers will have a tougher time finding buyers when they want to sell bonds. In the past, big banks would help with liquidity by buying when the market was too skittish, but new regulations are making banks less willing to step in when there's a sell-off in the market. Market watchers have been warning that liquidity is worryingly low.

Lower liquidity

Fund managers say they've already seen signs of lower liquidity. Prices for bonds move more quickly than they did in prior years, says Richard Lindquist, head of the high-yield fixed-income team at Morgan Stanley Investment Management. Last year, for example, when the high-yield market was struggling with the fallout from the plunge in oil, bond prices were quicker to fall. This year, as the high-yield market has recovered, prices have been quicker to rise. But he says he still can find buyers for bonds he wants to sell.

Regardless of how much confidence anyone has in high-yield bonds, most advisers say they should still be only a small portion of a bond portfolio. Wells Fargo's Kochan says they likely shouldn't be more than 15 per cent or 20 per cent, for example.

"It's very difficult to generate income outside of high-yield corporates," he says, "but it's only sensible to maintain some discipline."

- AP