Prudential Sees Junk Bonds Rallying On With Defaults Baked In

The rally that has made junk bonds among the best performing assets this year has room to run, according to Michael Collins at Prudential Financial Inc.

High-yield investors are still being too pessimistic at a time when global interest rates are expected to remain historically low, Collins said. That means the premium investors are demanding to hold junk-rated debt compared with safe government debt may tighten to 2014 levels that were the lowest since the financial crisis.

“We think spreads are wide,” Collins, co-manager of the Prudential Short Duration High Yield Income Fund, said Thursday in a television interview on Bloomberg <GO>. “There’s definitely scope for them to fall, especially if you think some of the defaults that everybody’s been waiting for maybe are already happening.”

Yields on speculative-grade debt were 639 basis points over comparable government bonds on Thursday, according to Bank of America Merrill Lynch data. They fell to as low as 335 basis points in 2014, a level not seen since since July 2007, more than a year before Lehman Brothers Holdings Inc. filed for bankruptcy.

The U.S. Federal Reserve’s main borrowing rate is 0.5 percent, down from a 25-year average of 2.86 percent, while some rates in Japan and Europe are negative.

‘Overvalued Situation’

Collins said the default outlook in the high-yield market remains “really varied” and corporate delinquencies in the commodities sector appear priced in. Outside of natural resources, he said many consumer-oriented sectors appear healthy. Prudential has been seeing attractive returns in bonds that are neither distressed nor the most defensive, he said.

“High-yield managers have flocked to that defensive, sleep-at-night part of the market which has arguably created even a potentially overvalued situation in those bonds,” Collins said. “The trick is finding those bonds in the middle.”

Junk bonds gained 7.7 percent through the end of April, compared with gains of 1.74 percent by the S&P 500 Index and 3.1 percent by Treasuries.

Collins’s Prudential Short Duration High Yield Income Fund was one of the few that eked a profit last year, and with a year-to-date gain of 3.4 percent is beating 85 percent of its peers in 2016.