Wed, 29 Feb 2012
With yield spreads back to pre-crisis levels, there is less room for error in the high-yield market today, says Morningstar director of fixed-income research Eric Jacobson.
Christine Benz: I'm Christine Benz for Morningstar.
High-yield bond funds have surged in the first part of 2012, and they've also seen a torrent of new assets.
Joining me to share his perspective on the category is Eric Jacobson. He is director of fixed-income research with Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: I am glad to be with you, Christine.
Benz: So, Eric, let's discuss the early innings of 2012. After so-so performance in 2011, high-yield bond funds have had very good numbers. What has been driving the good performance? Is it just the sense that the economy is getting better, ergo some of these highly leverage companies will be in better shape?
Jacobson: Well, I think that's part of it, certainly, but I also think that investors are chasing yield pretty hard right now. I think the Fed's declaration that they are going to keep short-term rates quite low for the next couple of years hasn't hurt in terms of spurring people into looking for higher-yielding assets now that they know they're not going to get it from some of the traditional places. I do think there is quite a bit of yield chasing.
Benz: Investors have decided that they've got to take on some extra risk if they are going to get a higher yield.
Jacobson: I think that's right.
Benz: Eric, within the category, I'm wondering if you can discuss what types of funds have performed especially well--has it been the riskier funds that have delved into lower-quality credits? What's driving the better performers in the group?
Jacobson: On average, you're looking at return since the beginning of the year for the indexes that are almost as large as they were for the entire all of last year, or at least those with a higher quality bucket, if you will, that was pretty large, within the high-yield category, in large part because of the falling Treasury yields. The higher-quality, high-yield bonds tend to be a little bit more sensitive to falling interest rates or rising interest rates, frankly. So, last year you got a little bit of a kick if you had some of that higher-quality stuff in your high-yield portfolio.
For the year-to-date, like I said, it's just about flipped. If you go and you look down at the areas of the high-yield market that have done the best, it's the most speculative areas that have returned the most for the year-to-date. And in fact, on average you're looking at returns since the beginning of the year for the indexes that are almost as large as they were for the entire all of last year.
Benz: How about the fundamental picture. Have defaults remained pretty mild within the high-yield space?
Jacobson: They have. If you follow this stuff real closely, you'll find that Wall Street is taking note of a slight uptick relative to last year, but it's still relatively low; the default rate is still under 2%, I believe, and I think their expectations are that it's going to remain on the low side of history, which is in the 4% range if you look at long-term numbers. It's almost certainly going to remain under that, in part based on the trends that we've seen, which are companies building up cash, deleveraging their balance sheets, and in fact, refinancing a lot of debt that had been outstanding. So, that's one of the ways that they are able to get that kind of visibility.
Benz: One thing I've heard from some investors, Eric, is that they like high yield because they see it as being relatively impervious in the face of potentially rising interest rates. Do you think that that's a safe assumption to make for fixed-income investors, or are there risks associated with that mindset?
Jacobson: I think it's a risky mindset from the perspective that it's something that can change. In today's world, if we had spiking interest rates, you'd have some protection, if you will, you'd have some resilience, if you will, from the high yield market not responding anywhere near as poorly, for example, as investment-grade high-quality bonds. And that's almost always going to be true, but if we continue on the path that we're on, which is that, investors are chasing that yield, they are grinding those yields down lower, prices are going up on high-yield bonds, the spread between what a Treasury bond pays and what a high-yield bond pays is going to get narrower and narrower. And the tighter that spread, the narrower that spread, the more sensitivity those high-yield bonds will display with regular interest rates. So, what may be true today may not be true 12, 16, 18 months from now if the market continues to go in the direction that it has been going.
Benz: So, you mentioned that spread or differential between Treasury yields and high-yield bond yields. I'm wondering, is there any sort of historical context you can put around this where that spread is now versus where it has been historically or are Treasury yields just so low that that's maybe not even a useful exercise at this point.
Jacobson: Unfortunately it's a combination of both, in the sense that, yes it's true that the low absolute number on Treasury yields is so low that it makes it hard to imagine that being a useful statistic, but then again, most of the alternatives that we would normally use, such as LIBOR or the level of swaps, which is sort of an extension of LIBOR, if you will, and you look out longer term, those are all pretty low anyway. That's part and parcel of the situation that we're in right now with all of the Fed easing and all the loose monetary policy and so on and so forth, and the relative health and banking industry, so to speak.
So, there isn't really a better tool to use, frankly, at this point. That said, the spreads, even if you just look at it and take that into account, they are getting relatively tight compared with history. I mean the hard part about the history question is, what does the average look like? Well, the average is affected by some pretty big things, like the spike in 2008 when high-yield bond prices went down, their yields shot through the roof, but where we are today is pretty close back to the yield levels of some of the heyday years prior to the financial crisis.
Now, that doesn’t mean we are in the same situation--the economy is different now, company balance sheets are different now, so I am not trying to say Chicken Little that you need to be worried because spreads are back where they were then, but the fact is, that does leave little room for error.
If you talk to different managers today, my colleague Sarah Bush, for example, just spoke with someone from Fidelity who said, people are acting as if there is just going to be smooth seas ahead in the high-yield market, and that’s something to constantly be paying attention to, because sometimes when the market thinks that everything is going to be nice and easy, that’s the time to start worrying.
Benz: A related question for you, Eric. I saw this morning that the three-year annualized return for the typical high-yield bond fund is 28%, and so anytime you see an asset class that has had performance that good, maybe not quite as good as equities, but still very good, should investors be approaching with caution, would you say?
Jacobson: Certainly, the word caution is apropos. I will see say, there is a little asterisk next to that number when you think about the fact that the base that high-yield bonds were coming off of three years ago was so low, because they had been beaten down so badly during the financial crisis. So, some of that number is just sort of a rebound to normal, and then, of course, some of it follows up from that.
If you look at the average prices of high-yield bonds, according to some things I just read from JP Morgan, they running at the par range right now, so 100 cents on the dollar sort of thing. A little bit higher in some cases. That tells you that they are certainly not cheap in the sense that you can't buy them expecting capital appreciation on average because you are getting something that had been marked down.
The real question is, does the economy continue to thrive, does it do better and better? That can still have an underlying current of reason for yields to grind down and prices to go up. And if you are convinced that we are in a strong economic rally at this point, that’s potentially where we are headed, but again, going back to that other theme, there is always a sense of risk and danger in the fact that everything seems to be priced for perfection right now.
Benz: So, if I am approaching this category, maybe I like it long term, are there any tips that you would espouse that I take? So should I dollar-cost averaging, or approach the more conservatively positioned funds? What do you think?
Jacobson: Well, I am big fan of both of those things. Certainly, dollar-cost averaging I like as an idea, because it does help smooth out some of those bumps. It makes ... even if you feel a little bit trigger happy and wanting to move money around a lot, which always runs you the risk of getting whipsawed by jumping in at the wrong time, dollar-cost averaging helps smooth that out.
I also think that there are lot of different ways to go with the funds, I have never been a big fan of the really, really aggressive funds that hold a lot of what we would call below B, usually CCC securities, even though they've taken up a bigger place in the market. But I tend to favor funds that have some flexibility and tend to run a little bit more conservatively, but there's all kind of choices there to go with.
Benz: The last question, Eric, I'd like you to name some specific funds. You kind of hinted that you like some of the more moderately positioned funds in the group. Let's talk about some of your favorite high-yield offerings.
Jacobson: Sure. Let me name a couple that my colleagues cover that I know that they're big fans of. One is Fidelity High Income; that's a real strong, good, fairly straightforward fund that we've gotten to know over the last few years and like quite a bit. Another one is T. Rowe Price High-Yield. That's also one that has done well navigating markets in the past that we like.
And some of these, by the way, based on what I said before about the way that things went last year with higher-quality buckets doing really well and vice versa this year, you will see some variability in the returns especially on some of the funds I am going to mention next. But I wouldn't necessarily look at that number and think, wow, they're not doing well over the last three or six months, so I really should be careful with this fund. I wouldn't judge too much on the short term. We tend to look at these things over longer periods of time: Are these folks successful in avoiding the biggest trouble, for example, not necessarily just, are they able to ride the biggest rally?
So, a few more that I would mention that our funds that we like for one reason or another: Metropolitan West High Yield; it's still a relatively new fund. I think it's only been around for maybe five years, and they've gotten caught a little bit in that back and forth over the last two years, but that's mostly as a result of caution.
Hotchkis and Wiley High Yield, which is run by a couple of managers named Mark Hudoff and Ray Kennedy who used to be mangers at PIMCO. It's still a new fund. It's not an unbridled, unqualified recommendation. We're still getting comfortable with the resources they have behind them at a smaller firm, but we think that they're really good managers, and that fund has the potential to be really good going forward.
And then the last one I'll mention is a longtime favorite of mine; it got caught in the switches a little bit back and forth here in the last year or so, but also a really solid team that we've liked--Eaton Vance Income Fund of Boston, another one that I think is a good option to look at.
Benz: Thank you Eric so much for sharing your insights into this category. I know it's really been on investors' radar, recently. So, it's great to hear your insights.
Jacobson: I'm glad to be with you, Christine. Thanks.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.