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A year ago, high-yield bonds were outcasts. The financial
world was bracing for Armageddon, and investors fled riskier
high-yield bonds in droves in anticipation of widespread
defaults. Yield spreads -- in this case, the difference
between yields on high-yield bonds and yields on "AAA"-rated
corporate bonds -- soared to a record high of 14% in the
beginning of April.
What a difference a year makes.
As panic from the financial crisis waned, investors came
back to high-yield offerings. As a result, the Merrill Lynch
High Yield Master II Index (a sector benchmark) soared
+52.7% in the first nine months of 2009, and the yield
spread came down to 5.8% as of mid-December.
Doesn't this mean the party is over?
History says no. While this past year's returns are unlikely
to be repeated, there are several reasons to believe solid
returns are still to be had in high-yield bonds. While the
spread has moved down to 5.8%, that's still +2% above its
average over the past 21 years, meaning there's room for
further gains.
 If
you look at the aftermath of bear markets for high-yield
bonds, the bonds experienced several years of strong
performance, not just one good year. After the sell-off in
high-yield bonds in 1990, the sector outperformed the
broader Barclays Capital Aggregate Bond Index through 1997.
Likewise, after a bear market for the high-yield bonds in
2002 they outperformed higher-quality bonds through 2006.
But aren't high-yield bonds inherently risky? Sure, there is
more risk than with higher-grade bonds, but there is also
more reward. The good news is that the corporate default
rate (a major barometer for measuring risk in the high-yield
market) appears to have peaked. Rising default rates add
risk to high-yield bonds and generally cause a sell-off in
price. However, the reverse is also true -- falling defaults
increase investors' risk tolerance and normally lead to
higher returns.
As the economy fell into recession, earnings were lower and
more companies had trouble making debt payments. In
addition, tighter credit markets made it difficult for
companies to refinance their obligations. According to
Moody's, the U.S. high-yield corporate default rate peaked
in November at 13.8%, the highest since 1991.
But in April, Standard & Poor's had predicted corporate
default rates would peak at 14.3% by March 2010. As economic
conditions have improved, this forecast has changed
dramatically. Standard & Poor's forecasted in October that
the default rate will average just 6.9% by September 2010, citing
improved credit markets and a better economy. As well,
Moody's has predicted the default rate to fall to just 4.5%.
In short, everything seems to be lining up for the
high-yield bond sector in 2010. An improving economy is
lowering default rates. Spreads are still at historically
high levels. And, historically high-yield bonds have been
attractive at this point in the market cycle.
How can you invest in this high yield opportunity?
There's no doubt one of the best ways is through a fund. The
diversification of funds (which usually hold dozens or
hundreds of bonds) greatly reduces the risk inherent in
owning just a handful of high-yield bonds. Funds also
usually provide the convenience and cash flow advantage of
monthly income.
With just a quick screen, I've uncovered about 200 different
high-yield bond funds with distribution rates as high as
11%, 12%, or even over 13%. But how can you select which
ones to own?
Before diving deeper, I like to look at a fund's performance
relative to its index and other funds. Performance is like a
fund's resume, and you can find ones that have consistently
performed well. Leverage is also an important consideration.
When a fund uses leverage, it borrows short-term money at
low rates and uses those borrowings to invest in
higher-paying bonds. However, if short-term rates rise, it
could reduce the spread the fund earns and put pressure on
its distribution and price.
With these items, in mind, I've started looking at the
iShares iBoxx High Yield Corporate Bond ETF (NYSE: HYG).
This unleveraged fund has only been around for a couple of
years, but its performance has matched up well with its
index.
In 2009 the ETF participated in the high-yield
bond bull market, returning +28.5%. Moreover, its 290
holdings -- and 9.3% yield -- could make this one of the
most attractive ways to profit from the opportunity in
high-yield bonds.
Good Investing!
Tom Hutchison
Carla Pasternak's Dividend Opportunities
P.S.
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