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By Sumit Desai, CFA | 07-01-2015 03:00 PM

What Should Investors Expect From High-Yield Bonds Today?

BlackRock's Jim Keenan discusses where we are in the credit cycle, bond-market liquidity, and why he likes bank loans.

Sumit Desai: Hi, I'm Sumit Desai--senior fixed-income analyst with Morningstar's manager research team. Joining me today is Jim Keenan, global head of credit at BlackRock. Jim is the lead portfolio manager of BlackRock High Yield Bond (BHYAX).

Jim, thank you for joining me today.

James Keenan: Thanks, Sumit.

Desai: As lead manager of the high-yield portfolio, obviously you have a lot of views on where we are within the credit cycle. Maybe you could spend a little bit of time talking about where exactly we are within the credit cycle and your expectations for the high-yield asset class going forward.

Keenan: We're definitely in the later stages of the credit cycle here. But the question is how much longer do we have and what types of assets and risks do you want to have at this point. And obviously, I think at this stage in the cycle is when you start to see a lot of the protections start to get stripped out of bonds. Covenants start to get weaker; you start to get more aggressive with regard to your management teams; and corporations start to add more risk, whether that's through M&A activity or shareholder-friendly buybacks and dividends and those types of things.

So, you really have to be disciplined on the types of risks that you're buying when you're adding leveraged credit risk or high yield or bank loans. I think you have to be disciplined, diversified, and really specific to the security level that you're buying. For the asset class as a whole, we have not viewed this as a great opportunity. The question is where we are in the cycle and the different types of risk rewards that you want to have. We're in a period of time where we're still in a low-growth environment. We're still seeing modest inflation, and the economy is still continuing to improve.

So, at this point in time, when you look at the world's fixed-income asset classes, 85% of them are still trading at less than 4%. When you look at equities, you still have high multiples right now. Nothing looks really cheap at the time when I would say volatility is coming back to the market. And so when we look at this, if the market over the next two to three years is going to be in a modest-growth environment--even though [volatility] is coming back--the high-yield asset class, we think, is looking at a 4% to 6% type of return. That's not attractive in historical terms, but it's still good in relative terms when compared with the risk of drawdown or volatility in the equities or the low carry or interest-rate risk that you might have at this point in the cycle in most fixed-income assets.

Desai: Obviously, a hot topic for all bond investors right now is the Federal Reserve and what they'll do with rates. How would you expect high yield and, specifically, your fund to perform in an environment where the Fed is raising rates?

Keenan: I think the Fed is going to obviously raise rates, and we still believe it's going to be a slow path, as they start to move away from their zero-interest-rate policy. And that's largely because of our expectations of modest growth and modest inflation increases. That is still positive from a corporate-earnings perspective, and it's still positive from a credit perspective. High yield and bank loans tend to do well in rising-rate environments that are coupled with an improving economic perspective. We think that, in the high-yield market, there is some volatility on the longer end--call it closer to 10-year high-yield bonds. But high yield still is relatively countercyclical, and so we think at a 500 [basis-point spread over Treasuries] that high yield will still do well. And again, that's mid-single digits. But relative to other fixed-income assets that might have a negative return because of a rising-rate environment, high yield still stands out as being pretty good in this part of the cycle.

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