• Investment Management

Why the Risk of High Yield Bonds Is Worth Taking

The risk of underperforming could be greater if you stay out of the high yield market, than if you increase your exposure, say Morgan Stanley Investment Management portfolio managers.

It was a spectacular display of bipolar behavior, even for the US high yield bond market. In the first quarter, a crude oil price of $26 per barrel and fears of a US recession had sent high yield returns plunging to negative 5.16% by Feb 11th. About four weeks later, the Barclays US Corporate High Yield Index whipsawed to a positive 3.75%, as investors suddenly rushed back in, convinced that oil had seen its lows and the US economy wasn't likely to fall off a cliff any time this year.

In typical form, investors were bracing themselves for the next mood swing, as April rolled around. Many an advisor was recommending the cautious route of, at most, keeping allocations to the market the same as benchmark indices, such as the Barclays Index. Yet, for those investors comfortable with the additional risks of investing in high yield, staying passive and simply hugging the benchmarks could be the worst strategy for this year, say Morgan Stanley Investment Management fixed-income portfolio managers, Jim Caron and Richard Lindquist.

“If you just stick to the high yield index, then you’re exposing yourself to a large swath of distressed names in the market,” says Lindquist, who heads up Morgan Stanley’s Global High Yield Team of  portfolio managers. “The first quarter has shown just how quickly this market can change, and US high yield default rates are returning to their historical average of around 4.5%.”1

Defaults have risen to 4.1 % in US high yield2, from around 2.6% in recent years, and they’re still rising, with energy, metals and mining accounting for 87%3 of all high yield bond defaults by the end of last year. The energy sector is also getting bigger by the day, as investment-grade companies on the cusp of high yield get downgraded.

Yet Caron and Lindquist believe that high yield bonds have the potential to outperform equities this year, particularly if default-riddled areas are mostly avoided.

“At this point, the risk of underperformance is greater if you stay out of the high yield market than if you increase allocations to corporate bonds,” says Caron, who runs the Global Fixed Income Opportunities Fund. “The markets rallied a lot in March, but we believe there’s still room for further improvement in both high yield and investment grade this year." 

By the end of March, the Barclays U.S. Corporate Index was returning 3.97% year-to-date, and the Barclays U.S. Corporate High Yield index was returning 3.35%. The S&P 500 was up 1.35%.

The Power of Policy

Lindquist is positioning for further improvement in high yield’s performance this year, beyond what was witnessed in March. One of the big drivers will be central bank policy, he says. In March, the European Central Bank announced a euro-denominated corporate-bond-buying program to stimulate the eurozone economy. That’s a potential game-changer for US bonds.  “We believe this is going to drive down yields in the Eurobond market, and that will cause foreign investors to seek out US dollar-denominated corporate debt for higher yield,” says Lindquist.

The Federal Reserve is also following a very low and slow rate rise at this point, by changing its expectation to only two rate rises this year, versus the four it had suggested last December. “The Fed knows that by tempering the dollar’s strength, it’s helping oil prices and keeping bond issuance cheap for corporates,” says Caron.

One opportunity to potentially boost returns comes from taking advantage of the occasions when investors, spooked by whatever news rattles the market, have dumped lower-rated Single-B bonds. This has caused the average trading level between Single-B and better-rated Double-B bonds to widen out, as Single-B bonds have dropped in price. These trading levels usually have returned to roughly what they were before the panic selling, and savvy portfolio managers can position themselves to potentially profit from this historical bond behavior.

Although the energy sector is highly unpredictable and a source of further defaults, Lindquist argues that it’d be a mistake to avoid it altogether. He skews his funds’ allocations toward higher quality bonds in commodity-related sectors. “Energy, metals and mining take up about 18% of the entire high yield market, so how you invest in those two sectors will determine much of how you perform this year,” he says. “You can’t avoid the energy sector altogether because you will miss out on the potential for a snap-back in bond spreads if demand and supply continue to normalize.”

Above all, the key to success is putting as much emphasis on being tactical as focusing on bottom-up fundamental analysis.

“Clearly, volatility is much greater now than it has been in years, so it’s become more of a market for tactical bond pickers, who know how to be in the right names and the right sectors at the right time,” says Lindquist. “That’s the way to help avoid defaults, while still providing alpha potential. If you can do that, then you are looking at a market that has the potential to provide very decent returns for the next six to twelve months.”

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