After a prosperous 30-year bull market, the prospect for the future direction of High Yield bonds would seem to hinge on not whether, but when their decline starts. Dan Fuss has been managing bonds for 55 years. His multi-sector bond fund, Loomis Sayles Bond Fund, ranks in the top 10% of its peer group over the last 15- and 10- year periods as of December 31, 2012. Fuss believes that bonds are currently “the most overbought market I have ever seen in my life in the business.” His comments near the beginning of this year show one side of the debate on bonds, though his views are not shared by all. Gershon Distenfeld, Director of High Yield Debt at AllianceBernstein, stated earlier this year that bonds are still not a high risk asset class. In fact, he believes that structural characteristics of bonds will prevent them from becoming a bubble. This institutional disagreement highlights the complexity of the bond market environment.
Fixed income securities have enjoyed strong recent gains. Looking at a longer period, gains in fixed income extend decades into the past, when high interest rates began their long-term descent, exerting a positive influence on bond prices. Yields on U.S. Treasuries are still low, but have crept higher. However, demand for bonds at these levels is still strong as evidenced by yields having not risen significantly, even as the economy shows signs of life. Fuss noted that yields have been suppressed because central banks have been buying bonds which is not sustainable. Interest rates will have to go up, which will cause most bond prices to decline, including High Yield bonds. “High Yield is as overbought as I have ever seen it,” he said.
Distenfeld held a different view. He contrasts the High Yield market with asset classes that have experienced bubbles in the past. His examples include tulips, housing, and internet stocks; gold could be added to the mix. These asset classes have been the subjects of fantasy and the targets of greed. Part of what made them susceptible to bubbles is the difficulty in determining their intrinsic value and predicting their returns. By contrast, returns for High Yield bonds are easier to forecast. High Yield bonds have more salient valuation reference points, including current yield and value at maturity. Investors may be reluctant to let prices get too far out of line with these fundamental metrics. Another point about bonds is that getting principal back, unless the issuer goes bankrupt, at maturity decreases the risk of extreme losses, which are the end result of bursting asset bubbles.
Fundamentals of the High Yield market and High Yield issuers remain strong. Leverage ratios are not excessive, balance sheets are in good shape and have actually strengthened due to deleveraging, lower financing costs, and healthy profits. Defaults remain low and are expected to continue to be low. A strong demand for income makes High Yield bonds an attractive asset class to many investors. However, it is important to note that High Yield bonds are more volatile than many other fixed income sectors. Distenfeld points out that in almost two-thirds of the years since 1990, High Yield bonds experienced peak-to-trough declines of at least 5% and declines of at least 10% in over one-third of the years. This has been normal for the High Yield bond market.
High Yield bonds have unique risk and return characteristics that can make them appealing for use within certain strategies. For example, a higher proportion of their risk is due to credit risk as opposed to interest rate risk. This can protect their downside in a rising interest rate environment. Whereas long-term U.S. Government bonds are incredibly sensitive to rising rates, High Yield bonds are more sensitive to credit ratings and economic growth. This can shield their total returns when interest rates rise. The unique properties of High Yield bonds make them appropriate for consideration in tactical management strategies to target price appreciation and income during positive periods while attempting to minimize downside risk in the event of a decline.
While the 30-year bull market in High Yield bonds justifiably warrants concern for its future direction, some investors think its unique valuation components and performance drivers help paint a less worrisome picture than with other asset classes experiencing similar long-term uptrends. While the downside risk is still there for High Yield bonds, tactical strategies that leverage the low correlation between High Yield bonds and other bond classes may find opportunity using a “right bond at the right time” approach.
An “adjustment period” for rates and spread products is likely to create drawdown in the High Yield sector as the yield premium of the average High Yield bond to the 10-year U.S. Government bond will need to widen from historically low levels. Moreover, stocks, as noted, may be due for a pull-back phase, and we are starting to see some consolidation. The consolidation in stocks also places stress on High Yields, even if we undergo a “relief rally” in U.S. Government bonds.
Indicators should react well to the trading opportunities that may emerge in U.S. Government and/or High Yield bonds during the adjustment process toward higher rates with the ending of the QE3 stimulus that has supported risk assets.
In our view, the key to bond investment management during the next 12 – 60 months of generally rising rates is to avoid a buy-and-hold strategy. Year to date, many bond indices have had significant losses and these could be largest in aggregate for buy-and-hold investors. Bonds have enjoyed a generally rising market since the 1980’s and posted some great annual rates of return, but the backdrop that has helped buy-and-hold bond investors seems to have changed for now.
Sources:
http://blog.alliancebernstein.com/index.php/2013/01/23/high-yield-wont-bubble-over
© BTS Asset Management
