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By Christine Benz | 02-29-2012 03:00 PM

Five High-Yield Funds for a Caution-Worthy Market

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.

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