High-yield bonds have arrived at an interesting spot: The spread over investment grade bonds is narrow, suggesting less reward for the risks investors are assuming, yet default rates are low, the U.S. economy is improving and the hunt is still on for investments that provide an attractive source of income.
Are they a buy? John Addeo, portfolio manager at Manulife Asset Management, pointed out that high-yield bonds – generally non-investment grade debt – have been navigating shifts in the economic backdrop remarkably well.
The sell-off that walloped fixed income investments in the second quarter – when attention shifted to the prospect of the Federal Reserve winding down its bond-buying program – barely affected high-yield bonds, which tend to be less sensitive to changing views on interest rates.
Indeed, the junkier the bond, the better the performance throughout 2013, with triple-C-rated bonds delivering double-digit returns as economic fundamentals improved and the risk of default declined.
"If indeed fundamental data is improving, then, by extension, credit-metrics are improving," he said. "So the underlying quality of the businesses is getting better."
That means there is the potential for rising bond prices and additional spread compression, either driving up total returns or at least offsetting the impact of rising rates. That makes high-yield bonds look like a decent bet in 2014 – especially given that many strategists are forecasting modest gains for U.S. stocks after a 25 per cent return in 2013 has rendered them fully valued.
Meanwhile, the improving business conditions have driven down default rates to about 2 per cent, and Mr. Addeo doesn't see much deviation from that over the next several years.
"While people seek out income, high-yield bonds continue to offer attractive levels of income," he said, pointing out that yields are averaging about 5.7 per cent.
Yes, spreads over government bonds have narrowed to about 400 basis points (or 4 percentage points), but there is room for more: In 2007, the spread narrowed to about 250 basis points. And the low default rate means that investors are being rewarded adequately for the risks they are taking.
"We are being fairly compensated for default risk, as long as that default expectation is correct," Mr. Addeo said. "And we think it is because the economy is recovering, the fundamentals are improving – and companies have been able to refinance and reduce their cost of debt."