High yield bonds offer new opportunities for returns

“The global high yield bond market has made off to a good start in 2011, with returns of approximately 3.2% [1] through mid-March. High yield bonds have been resilient during the recent equity volatility. Demand for high yield bonds has been strong, with mutual fund inflows of US$9 billion, or 4.6% of fund assets, year to date, according to AMG Data Services. We are also seeing even larger demand for leveraged loan funds in anticipation of hedging inflation risks due to their floating rate structure.”

“That said, the yields in high yield bonds are near all time lows at just over 7% [2], and we therefore reiterate return forecasts of 7% to 8% for high yield bonds and 6% to 7% for leveraged loans for 2011. These remain attractive rates of return when compared to investment grade fixed income alternatives.”

“While yields are low on a historical basis in the high yield market, we are seeing opportunities to increase total return by finding bonds with the potential to ‘cross-over’ into the investment grade universe. Upgraded bonds become open to a larger universe of buyers and typically have price appreciation as their risk premium, or spread, narrows. For example, a BB+ rated bond such as Macy’s, the department store, trades with roughly a 5% [3] yield, however a potential return would be closer to 9% if the bond is upgraded to investment grade as its spread tightens.” A number of key market indicators support a marketweight allocation to high yield bonds and leveraged loans:

1. Global default rate is low and expected to fall further: The probability of default has been lessened by firms’ extensions of maturities at attractive rates, large cash balances, improved operating leverage and higher profit margins.

2. Low real rates supporting narrow high yield spreads: A low real rate environment has been accommodative for the high yield market, helping provide a low cost of capital for refinancing and extending maturities.

3. Credit rating trends most favourable since 1998: Strengthened corporate balance sheets and robust earnings support a credit rating upgrade environment and the trailing 12-month downgrade/upgrade ratio is near an all time low.