Junk Is Not Bunk

When the Federal Reserve signals an imminent rate rise, the news is traditionally greeted like a general alarm in the high-yield bond markets: “Get out while you can! Run for your lives!”

But there are many who believe that a knee-jerk response would be imprudent at this time. It's true that rising interest rates typically hit the high-yield group hard. Indeed, some issues already are suffering at the hands of rising interest rates.

Considering the alternatives to fixed-income money, though, the high-yield market (bonds with credit ratings lower than BBB-) doesn't look so bad.

“You have to look at high yield versus the alternative,” says Martin Fridson, publisher of Leverage World, an independent high-yield bond research service. “Since rates started rising with a vengeance, high yield has been the place to be. If clients have realistic expectations, it's a pretty good place to be.”

The stronger economy has kept high-yield returns above their safer counterparts, even as rates have started climbing, says Fridson, who spent 25 years as a high-yield guru at Merrill Lynch and other brokerage firms.

The Price of Labor

Interest rates spiked after the U.S. Labor Department reported strong jobs figures April 2. High-yield bonds fell 0.27 percent from March 31 to April 22. But 10-year Treasurys declined a whopping 3.95 percent in the same span.

Of course, rising rates hurt high-yield bonds at first. As interest rates rise, the yield spread between Treasurys and high-yield bonds narrows, and the interest rate premium investors get for taking on the higher risk of junk bonds gets smaller.

The same thing happened when rates rose in 1994. High-yield returns fell 1 percent, but 10-year Treasury returns plunged 8 percent.

Higher rates are a double-edged sword for high-yield bonds. Bonds sell off when rates rise, but high yields' interest rate premium shrinks for the same reason that rates are rising: The economy is picking up steam. That means even high-risk companies become less likely to default on their debts; thus, high yields' relative performance shines.

In 1994, high-yield bonds continued to pay higher yields than other bonds as interest rates rose, but their risk and their default rates start to look like investment-grade bonds.

“As long as you're not suffering permanent principal losses, I'd rather have the higher income of high yield,” Fridson said. “That's the trade-off right now.”

Further, as the spread in yield between high yields and Treasurys compresses, it helps high-yield prices relative to the rest of the bond market, says Gary Rodmaker, portfolio manager of the Summit High Yield Fund. If compression happens because high-yield bond yields decline, their prices rise. By contrast, if Treasury bond yields rise, their prices fall. Either way, high yields do better, at least relative to the rest of the fixed-income market.

The spread between high-yield bonds and Treasurys in 2002 was about 800 basis points. This year, it has narrowed to about 450 basis points, closer to the historical average, Rodmaker says. He doesn't see much further compression.

As the two competing forces of rising rates and better default rates offset, investors should be able to earn the yield of these bonds, without much price fluctuation either way, says Scott Berry, bond fund analyst at Morningstar.

“Relative to other areas of the bond market, it doesn't look to be a bad time to get in,” Berry said. “But you have to be ready to accept less than last year.”

Dull by Comparison

Last year was the best year for high-yield bonds in more than a decade, as the Merrill Lynch High Yield Master II Index gained 28.15 percent. As the economy gathered strength — the gross domestic product rose 3.1 percent for the year and soared 4.1 percent in the fourth quarter — it held down defaults, fueling returns.

This year, high-yield bonds have returned to a more normal 2.2 percent gain through the first quarter.

“A lot of capital gain potential has been wrung out of the market,” Berry says. “Demand for high yield could be drying up.”

Instead, high-yield investors will have to rely on issuers paying back their debts in order to make any returns this year. Thanks to the surging economy, the trend bodes well for that.

High-yield default rates peaked in late 2001 and early 2002 at about 11 percent. They've plummeted since then, hitting 5.2 percent last year and an annualized rate of 1.9 percent in this year's first quarter, says Diane Vazza, Standard & Poor's head of global fixed-income research. That pace would make this the best year since 1996 for defaults, which average 5.3 percent.

With business conditions continuing to pick up, defaults are likely to stay low and could even go lower, Fridson says.

“This looks like a replay of the 1993 to 1995 market,” Rodmaker says. “It's almost an eerie similarity.”

Defaults peaked in 1991 and 1992 at about 11 percent. They fell to 3.5 percent by 1993. After high-yield bonds fell slightly in 1994, they enjoyed double-digit returns the next three years. They beat the 10-year Treasury, 14.9 percent a year to 11.2 percent, from 1995 to 1997.

“In a period where spreads are exceptionally tight, high yields did far better than Treasurys,” Fridson says. “You can't count on that all the time, but the underlying economy is so favorable that you get rewarded for taking the incremental risk.”

Before You Leap

Still, Rodmaker isn't telling investors to plunge headfirst into high-yield bonds.

“I don't think it's a great time to be in the fixed-income market at all, but if you're looking at fixed income, this is where you should be,” he says. “It'll be very good for high-yield investors to earn their coupon this year. If they get 7.5 to 7.75 percent this year, they should be happy.”

High yield makes up about 4 percent of the bond market. Fridson says it should constitute 10 percent to 15 percent of most investors' bond portfolios. Even at that, investors have to be able to stomach the uncertainty that comes with it. The low default rate offers some safety, but that won't last forever.

More low-rated issues than usual came to the high-yield market last year. It typically takes two to three years for companies to start defaulting.

“Defaults should be good through 2005,” Fridson says. “But there ought to be some escalation starting in 2006.”

High-yield returns could suffer then, but even though the market is a discounting mechanism, it's not likely to look that far ahead, Rodmaker says. And it's hard to pinpoint a time when defaults will rise.

“It's a matter of when the economy peaks and comes back down,” Rodmaker says. “That's when we see these things coming home to roost.”

Until then, he says, the high-yield market looks pretty stable. Don't expect a repeat of last year's returns. But if your clients would be happy with a 7 percent gain in bonds, high yield is still the place to look.

Steve Watkins is a freelance writer based in Cincinnati.

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