High-Yield Bonds Hit a Few Bumps, But Still Appeal to Risk-Takers

“Junk” has been the jewel of the bonds world, but are yields still attractive?

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High-yield bonds and the mutual funds and exchange-traded funds (ETFs) that hold them are meant for risk-takers, by design. Now, after a lengthy run at beating lower-risk bonds and the stock market at large, the "junk" bond sector may be losing a little of its shine.

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Spiking European bond yields, slowing Chinese economic growth, and lack of a pledge for further stimulus from the Federal Reserve prompted investors to pull $1.18 billion from U.S. high-yield and related mutual funds and exchange-traded funds for the week ended April 11, according to EPFR Global data. It was the first outflow in more than four months.

Still, some analysts say the fundamental picture for high-yield bonds hasn't changed.

A global hunt for yield (particularly from aging investors) and cleaned-up company balance sheets will underpin demand, says Michael Collins, senior investment officer at Prudential Fixed Income. The bonus in a low-interest rate environment? Companies have been aggressively refinancing their debt and improving their credit standing. That's boosted European investing demand for access to the much deeper U.S. bond market, including high-yield debt.

The high-yield market is different than it was three years ago, bringing new issuance of $850 billion, about two-thirds of which has been refinancings to take advantage of lower rates, according to Sabur Moini, manager of the Payden High-Income Fund (PYHRX), which tends to focus on the upper tier of BB or B-rated bonds.

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With the nickname "junk bonds," the category covers debt that carries credit ratings below Baa3 by Moody's Investors Service and less than BBB- by Standard & Poor's. Junk bonds have been major income generators, outperforming higher-rated bonds and equities in the years since the 2008 financial crisis and recession. But investors aren't getting paid as much for taking on that risk as they have in the past. These bonds pay more because with them comes the perception that a company is more likely to default on paying interest or principal.

The current high-yield default rate is running at about 2.5 percent, below the 4.5 percent average over the last 20 years, says Moini.

Demand for high-yield bonds has been unprecedented, with investors funneling $23.5 billion into junk funds in a 16-week period ending in late March, according to a report from JPMorgan Chase & Co. Speculative-grade debt globally is up 7 percent this year, compared with 3.8 percent during the same period a year ago, according to Bank of America Merrill Lynch index data.

For the longer haul, at least one firm is banking on strong demand for access to high-yield bonds. BlackRock/iShares announced this month that it's planning a global junk-bond ETF following the popularity of its first high-yield debt ETFs. The fund will use indexing to reduce some of the risks typically associated with active management, such as poor security selection. The firm's iShares iBoxx High-Yield Corporate Bond Fund (HYG) launched in April 2007 and with $14.3 billion in assets, has grown to be the world's largest junk-bond ETF.

For now, though, high-yield confidence may be wavering, at least a touch. That's a potential sell signal for some, but a buying opportunity for others.

JPMorgan strategists have become cautious, turning "tactically neutral" in high-grade, high-yield, and emerging-market corporate bonds, they said in the report. "Until the U.S. economic data firms and reassures investors the year-to-date improvement was not due to either seasonal adjustments or the warm winter, the asset class is unlikely to make headway with the market now seeing outflows," the strategists said.

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"Our view is for a low-rate environment for at least 12 to 18 months," says Payden's Moini. "The U.S. economy has slack in employment and China is slowing down. But the global economy is still growing and Europe's political leadership has shown some mettle. Greece [debt issues], maybe, were papered over, but officials look ready to prevent the spread of Spain's problems. Upcoming elections [in Greece and France, for example] do pose some uncertainty."