Rethinking Those Hot High-Yield BondsBen Levisohn
Junk bonds are red-hot. In the week ended Oct. 23, $5.5 billion of new high-yield debt was issued, with deals from RiteAid (RAD) and ViaSat (VSAT) closing out the week. Issuance this year has topped $118 billion, nearly twice as much as in all of 2008. Investors have reaped the benefits, with high yield bonds returning nearly 50% year-to-date.
Returns of that magnitude in such a short period of time naturally cause some investors to worry. As junk bond prices rise, yields have fallen—from 15% on February 27—based on the Bloomberg U.S. Dollar Composite (B) curve—to 9% today. Amid the massive issuance and the monumental gains, some market observers are starting to mutter about a new credit bubble. Are high yield bonds, they wonder, truly junk?
They needn't be so worried. Take the increased issuance. High-yield borrowers have two choices when it comes to taking on debt—bonds or loans. The loan market pretty much shut down, which has sent high-yield borrowers rushing to issue bonds. The new bonds, however, aren't like the "covenant-light" bonds issued in the 2006 LBO boom that carried few safeguards for investors. The new deals come with covenants that are borrowed from the loan and mezzanine market, including leverage ratios, interest coverage ratios, maximum capital expenditures, and cash sweeps, which require borrowers to buy back bonds if cash levels are above a specified amount.
junk: no longer historically cheap"These are good things," says Alex Gendzier, a partner at law firm Jones Day. "Not a sign of an overly aggressive bubble."
While yields have been cut in half, sending prices skyrocketing, they've come down from unprecedented levels. At 20% yields, bonds were pricing in default rates of greater than 20%—basically, depression levels. With the market now expecting default rates to be under 10%, junk bonds have yields of around 10%, roughly equal to what they were before Lehman Brothers' bankruptcy and to their yield at the end of the last recession in 2003. In other words: not historically cheap.
So if investors are judging the market based on recent returns, they're asking the wrong thing. "The question isn't: 'Are you going to have more defaults?'" says Matt Freund, portfolio manager of USAA High-Yield Opportunities Fund (USHYX). "It's 'Are you going to have more than the market expected?'"
That depends. If gross domestic product grows at a decent clip, company sales and profits continue to improve, and debt levels keep falling, bonds should outperform, says Darrin Smith, portfolio manager of the Principal High Yield Fund. He expects this to be the case.
The Middle Ground: Apportion for riskBut John Boland, a principal at Maple Capital Management, looks at the numbers and sees a different story. For starters, he doesn't think the economic recovery in 2010 will be as robust as it was in 2003. Back then, the budget deficit was relatively low, the economic recovery was more visible, and the dollar was strong and getting stronger, attracting foreign capital. "None of those conditions exist currently and may not exist next year," Boland says.
The answer, then, may be to split the difference. Investors might be wise to count high-yield bonds as part of their risk-asset portfolio—that means stocks—and include high-yield municipal bonds, too. That way, investors have some exposure to speculative-grade debt, which could result in nice returns if the market continues to go up. Avoid too much exposure, however, lest the economy take a further nosedive.
"We could see the market retest the lows. But we could also see things normalize faster than anyone ever thought," says William Larkin, a portfolio manager at Cabot Money Management. "Nobody really has any idea what's going on right now."