High yield junk bonds do better in a slow growth economy

AT first glance, high-yield bond funds had a strong start to 2016 with a first-quarter gain of 2 per cent. But if you were paying closer attention, the ride was anything but smooth.

In the first six weeks of the year, the largest high-yield bond fund, BlackRock High Yield Bond, lost 4.6 per cent, and the biggest exchange-traded fund, iShares iBoxx High Yield Corporate Bond, shed more than 5 per cent. During that time, the Vanguard Total Bond Market index fund, the largest fund that sticks with stodgy Treasurys and other high-grade bonds, gained 2.4 per cent.

The steep losses through mid-February were the latest illustration that high-yield bonds are an unequivocal failure when it comes to delivering on the classic role of fixed-income investments: ballast that steadies your portfolio when stocks are off on one of their depressive jags.

While it makes perfect sense to shun high-yield bonds - also known as junk bonds - for the part of your portfolio that you rely on for stability and predictability, completely swearing off junk could be a failure of portfolio imagination.

Junk bonds can play a useful role, as part of the riskier, stock side of your portfolio. In that context, junk bonds are fairly reliable, delivering higher income than dividend-paying stocks.

For example, the Vanguard High-Yield Corporate bond fund has a current yield near 6 per cent, compared with 3.2 per cent for the Vanguard High Dividend Yield index fund. The lofty income payouts of high-yield bonds have been the major driver of equity-like total returns over long stretches. From 1983 till the end of 2015, the 8.8 per cent annualised return of an index of high-yield bonds captured 80 per cent of the gain for the Standard & Poor's 500-stock index, with about half the volatility of the stock index.

An analysis by AllianceBernstein found that if you kept 75 per cent in stocks over that stretch and moved the other 25 per cent into high-yield bonds, the 10.4 per cent annualised return trailed the all-stock return by less than a half a percentage point, while clocking in with 16 per cent less volatility than the all-stock portfolio.

"There's a pervasive attitude that high yield is scary, but that misses the big opportunity," said Gershon Distenfeld, director of high yield at AllianceBernstein.

"Used in place of stocks, it dampens your volatility without costing you much in return." And junk is one of the better value propositions among riskier asset classes these days. After a sharp sell-off throughout much of 2015, the yield on an index of high-yield bonds at the end of the first quarter was 8.4 per cent, about 2 per centage points higher than a year ago. The total return for a traditional mutual fund or an ETF is the sum of the income yield plus any changes in the underlying price of bonds in the portfolio. Higher yields provide more cushion against falling prices during market downturns.

Starting from today's higher yields, Payson Swaffield, chief income investment officer at Eaton Vance, thinks we are at the beginning of a new cycle of positive junk returns that could last a few years.

One way to measure value is to compare interest payouts. The long-term trend is that junk yields are on average 5.25 percentage points higher than yields from Treasurys.

Right now this spread is 7 percentage points, meaning investors are getting paid more than the historical norm to dip a toe into the junk bond market.

Mr Swaffield found that in the two dozen times since the late 1980s when the spread was that wide, the annualised total return for high yield over the next three years ranged from 8 to 16 per cent.

Even sticking to the low side of that analysis, junk looks attractive relative to stocks. More than seven years into this bull market, stocks are anything but cheap, especially the high-yielding dividend payers that income investors have flocked to in a world where quality bonds yield next to nothing, or less.

The 19.2 price-earnings ratio for the iShares Select Dividend ETF is about 20 per cent higher than the long-term market norm. The higher the P/E ratio, the worse the value.

Robust economic growth could in turn spur solid earnings growth, which would help stocks post strong returns from today's lofty levels, but that isn't expected. S&P Capital IQ, a research firm that serves the financial industry, projects that the S&P 500 will post 1 per cent earnings growth this year.

"An economy that feels like it is running through mud doesn't look good for stocks at current valuations," said Raymond Kennedy, a portfolio manager of the Hotchkis & Wiley High Yield fund. "But high yield can do well in a slow growth economy." As long as cash flow remains positive, high-yield issuers can make interest payments even if earnings growth slows to a crawl.

Research Affiliates, a global asset allocation and investment company, forecasts that today's high stock valuations and low growth expectations could translate into an inflation-adjusted 1.4 per cent annualised return for the S&P 500 over the next 10 years.

The expected return for junk bonds is 3.4 per cent, the firm estimated. Investors may have begun to notice that mismatch; Morningstar reports that high-yield mutual funds and ETFs had net inflows of US$4 billion in February, the first positive month since October.

While junk bonds are generally less volatile than stocks, don't presume this will be a placid cruise.

Defaults are always a front-and-centre concern. In a recent analysis that made the case for junk being one of the better asset values in the market, Ben Inker, co-head of asset allocation at GMO, noted that the 4.6 per cent average default rate for the bonds since 1988 ranges from a high of 15 per cent to a low of less than 1 per cent.

Defaults are expected to rise this year from 2015's 3.5 per cent pace. Junk issues tied to energy, metals and mining represent about 18 per cent of the value of outstanding junk debt. Mr Swaffield of Eaton Vance said the entire junk market is trading at a level that prices in a default rate of about 18 per cent - as if everything linked to the battered commodities market were doomed.

Moody's forecasts an overall default rate of 4.7 per cent over the next 12 months, a bit lower than the 6 per cent projected by Eaton Vance. NYT