In the wake of the 2008 financial crisis and the recession that followed, a steady flow of assets has moved out of equities and into fixed-income investments. High-yield bonds have been especially popular as investors reposition their portfolios for an environment of slow but positive economic growth, ultra-low interest rates and fully repaired credit markets.
High-yield bonds sharply outperformed equities during 2009, returning 58.2% versus 26.5% for the S&P 500 Index (see Table 1). For the first three quarters of 2010, the Barclays High Yield Corporate Index has returned 11.53%, compared to the S&P 500’s 3.9% and the Barclays Aggregate Bond Index’s (investment grade proxy) 7.94%.
Colin Robertson, managing director of fixed income, Northern Trust, thinks the high-yield market may continue to do well in comparison to equities. The consensus economic outlook, calling for modest growth and near double-digit unemployment, should be good enough to allow most high-yield issuers to meet their debt payments. The bar for stocks, however, is higher. Equity investors need economic growth to be strong enough to produce steadily rising earnings over time.
“High-yield bonds continue to look attractive on a risk-adjusted basis and may fit within a well-diversified portfolio,” says Robertson. “They may be about as close as you can get to potentially achieving equity-like returns without owning equities.”
Record High Issuances
Corporations have been issuing high-yield debt at a record pace, taking advantage of the low interest rates and strong demand for all types of fixed-income assets. During the week ending August 13, 2010, 29 different high-yield issuers sold an unprecedented $20.6 billion in debt. “With Federal Reserve policies expected to keep interest rates near record lows for the foreseeable future we expect the pace of high-yield issuance to stay strong,” says Robertson.
Many companies with below investment-grade credit ratings have taken significant steps to improve their balance sheets and competitive positioning in recent years. By extending maturities on bank loans and refinancing upcoming bond maturities these issuers have improved their debt structure and lowered default risk. Indeed, the issuer-weighted U.S. speculative-grade default rate was only 4% in the third quarter of 2010, according to Moody’s Investors Service September Default Report.
“Corporate America went into the recession in relatively good financial shape,” said Bob Browne, Northern Trust’s chief investment officer in an online interview with Steve Forbes. “Corporate balance sheets are strong and corporations are building up a lot of cash. This bodes well for the high-yield market as many firms will be able to withstand a sluggish economy.”
Research is Key
Northern Trust’s research team seeks to identify high-yield issuers poised for a ratings upgrade. Working closely with portfolio managers, the team analyzes macro economic factors, technical market drivers as well as the credit fundamentals of specific borrowers to ensure adequate compensation for buying a company’s high-yield debt.
“Research is extremely important in the high-yield bond market,” Robertson says. “We look at a variety of criteria as we analyze opportunities and determine whether or not to add a name to our portfolios. Included are such things as refinancing risk, balance sheet strength, competitive positioning, industry growth prospects and the experience level of company management.”
Impact of Rising Interest Rates
When compared to investment-grade corporate and U.S. Treasury securities, high-yield bonds are typically hurt less by rising market interest rates. “High-yield bonds are more insulated from increasing rates,” Robertson says. “When interest rates jump, high-yield spreads (relative to U.S. Treasuries) typically narrow. Rising rates often coincide with better economic news and foreshadow improvements in revenue and earnings performance, both of which strengthen a borrower’s credit fundamentals.”
Although Robertson does not see any concerns on the horizon likely to negatively impact the high-yield market, he is on guard for warning signals. For example, any sudden dislocation in the credit markets that limits a corporation’s ability to rollover maturing debt would be a worrisome red flag.
“We are highly alert to changes in the liquidity and functioning of the primary and secondary credit markets. Should either start to function poorly, making it difficult for companies to issue, extend or refinance debt, we would likely take action to reduce our high-yield exposures,” explains Robertson. “However, with the Federal Reserve poised to inject additional funds into the market, we are not anticipating a deterioration in market liquidity anytime soon.”