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By Christine Benz | 10-06-2011 01:41 PM

A Gameplan for Playing High Yield

Although the default picture has improved in high yield, junk bonds could still get clocked if the economy falters or we face a double-dip recession, says Morningstar's Eric Jacobson.

Christine Benz: I'm Christine Benz for Morningstar.com.

Although high-quality bonds have been an oasis amid the recent stock market sell-off, junk bonds haven't fared as well.

Here to add some color to what's been going on in the junk bond world is Eric Jacobson. He is director of fixed income research for Morningstar.

Eric, thanks so much for being here.

Eric Jacobson: Good to see you. Thanks.

Benz: So Eric, there has been a lot of volatility in the junk bond space. The typical junk bond fund in our database is down something like 6% over the past couple of months. What has been driving junk bonds down?

Jacobson: Well, junk bonds tend to be sort of a proxy, if you will, in terms of observing them, for this kind of risk-on, risk-off trade that people talk about in the depths of the fixed-income markets. This is just another way of saying that when investors get spooked, and they start selling riskier things, especially if it's equities, the high-yield market tends to follow.

Benz: It's pretty correlated.

Jacobson: That's right. And it also tends to be kind of a very technical market as well, meaning that, if you have flows going in or out, they really can impact the market very strongly, because a lot of it's retail money, a lot it's in funds, whether it's retail or not. And so flows can really make a really big difference, too.

Benz: So, worries about the economy driving down the stock market also affecting some of these bonds?

Jacobson: Absolutely. Like I said, ... quite correlated to the stock market often.

Benz: So, any time you see a sell-off, like the one we've had in these bonds, I think people start to look and say, "Well, is there an opportunity here?" Certainly, yields have popped up on junk bonds and junk bond funds. What are you hearing and what do you think about the attractiveness of the sector right now?

Jacobson: Sure. Well, the bull case is out there in the sense that the investment banks are definitely out there saying now is a time to take high-yield risk rather than other kinds of risk. And some of the underpinnings of that, some of the fundamental arguments, have to do with this notion that balance sheets are in relatively better shape, the maturities that are facing high-yield companies are, as we like to say, "termed out" a little farther than they had been, especially since the time of the bulk of the financial crisis, where those maturities were coming up soon. And now we are at a point where a lot of companies were able to put their debt, their refinancing dates, way off.

Benz: So, no imminent need to refinance this debt?

Jacobson: That's right. Exactly. So even if they have a little bit of rough time, they're not going to be faced with a situation where they are going to have to go out to the market and borrow again. And of course you add to that the fact that yields are very generous. An a sort of average basis, if you will, they're up in the 10% range. And depending on the quality strata you're looking at, it can go anywhere from about 8% for a BB range bond, that's just inside the high-yield territory, all the way to crazy numbers like 14% plus for the CCC, really junky stuff, which, for better or worse, takes up a lot of the market today; that helps bring up that average.

Benz: So, I know people always say you want to look for a certain spread between junk bonds and Treasuries before you are a buyer? Is it there yet?

Jacobson: Well, look, unfortunately, those metrics are a little bit out the window in terms of their utility, because there was a time, especially when Treasuries were at normal levels, where you used to see something like 400 basis points to 600 basis points over. Today, we're looking at these numbers--these numbers are just not completely out of whack, because on an average basis, you're talking about 1,000 basis points in yield.

Benz: ... Because Treasury bond yields are so shrunken right now.

Jacobson: Well, just on a nominal basis, maybe 10% on average for the index would put you at--that's equivalent to 1,000 basis points--where the 10-year treasury only yields about 190 today. So, that spread is so wide, at some point, it becomes less of a useful information tool.

I think the real question is, what can we expect in terms of volatility in the future? And the risk of getting out front and saying, "yeah, go ahead and buy high-yield today" is that we don't know what we are facing with this economy. It still remains such a big question mark. There are so many big question marks about China. They still remain to some degree about the European banks.

So the point is this: There are really good fundamental reasons to say, "Hey, we don't think we're going have defaults." The companies look better. Their fundamental health is probably on the better side of things right now. But anyone recommending these would be a little foolish to not warn people that, "Hey, just because the fundamentals look good doesn't mean that more pain, like a double-dip recession, couldn't cause a sell-off in high yield," because if we get to that point, even if the fundamentals look decent, we expect the companies to stay in business and what have you, their bonds could still get clocked.

So, there is a part of me that wants to say, "Hey, at a 10% yield on average, that's not a bad thing. If nothing happens to the price, you collect the 10% return from the coupon. You're in a pretty good shape." But if you do that, if you see this as an entry point, you still have to be prepared for the fact that we're in a very unpredictable market. And I'll give you an example: Miriam Sjoblom, one of my colleagues who is a bond specialist, she's been talking to managers, who said, "Even at these yields, I'm still not all that crazy excited," because they take that sort of market volatility into account. So, that's a reason for pause.

Benz: These are opportunistic managers, who can invest in a lot of different stuff, not just junk bonds, and they're saying, maybe not.

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