The High-Yield Dilemma

High-yield corporate-bond mutual funds have surged in popularity so far in 2011. They took in $7.0 billion in new money during the first two months of the year alone, according to Morningstar estimates, which comes close to matching the category's $7.6 billion intake during all of 2010.

But are investors too late? Some could be chasing the impressive gains junk bonds have posted in recent years. High yield took a big hit during late 2008's financial crisis when frozen credit markets and rising defaults pushed yields on these bonds above 20% and prices below $60 (on par notional value), on average. But it rebounded with a vengeance beginning in March 2009; the Barclays Capital U.S. High Yield Index gained a record 58% that year. The sector's advance slowed somewhat in 2010, but the typical high-yield fund still managed to generate a 14% gain last year, almost matching the S&P 500's performance. Capital appreciation made up a significant component of the sector's performance in both of the past two years. The average dollar price of bonds in the Barclays index rose in 2009 to $95 from $61, and then to $102 by the end of 2010.

Those heady gains are over for now. With the index's average price above $103 currently, there's very little room for prices to rise further. Many of these bonds include call features, which limit how high dollar prices can go; issuers have an incentive to call their bonds when they're trading at a premium, because it means they can issue new debt more cheaply. The sector's potential income returns also appear muted: The Barclays index's 7% yield is near the low end of its historical range. The last time the index was priced above $103 was early 2005, when it also yielded a little less than 7%. That year, the typical high-yield bond fund returned just 2.6%.

It's All Relative
But even though absolute yields look low today as well, they still have some appeal relative to Treasuries and other high-quality bonds. That's a key difference between today and 2005. The yield gap between the average junk bond and Treasuries is currently around 5 percentage points, which is just below the long-term average. But back in 2005, high-yield corporates looked even pricier in relative terms, offering just 3 percentage points of additional yield over Treasuries.

Investors are more nervous about interest-rate risk today, too. Although the prevalence of call features can limit high yield's upside, they also lower the sector's duration, a measure of interest-rate sensitivity. In a March report, Bank of America Merrill Lynch notes that an increase in callable issuance and shortening noncall periods has caused the sector's overall duration to drop to its lowest level ever. The extra yield cushion junk bonds offer over Treasuries can also blunt the impact of rising Treasury yields. The sector demonstrated its resilience during the latest Treasury sell-off. The Barclays Capital U.S. Aggregate Bond index tracker  Vanguard Total Bond Market Index (VBTLX) lost 1.6% from Nov. 1, 2010, through Jan. 31, 2011, while sibling  Vanguard High Yield Corporate (VWEAX) gained 1.7%. More aggressive high-yield funds performed even better; the CCC heavy  Fidelity Capital & Income (FAGIX) gained 5.4% during that stretch, for example.

For these reasons, many diversified bond managers like high yield today. BlackRock's CIO Rick Rieder points out that a dearth of yield available in other sectors could continue to drive investors into junk bonds in the year ahead. He notes in a recent commentary that his team especially likes "higher-quality high yield, such as credits in the BB segment of the market, which provide a considerable yield pickup relative to BBB credits without displaying meaningfully weaker credit characteristics." Investors take some comfort from today's low default rates and rating agencies upgrading more bonds than they're downgrading. A number of intermediate-term bond funds with the flexibility to own non-investment-grade bonds have loaded up on high yield lately. Funds such as  Janus Flexible Bond (JAFIX),  Delaware Diversified Income (DPDFX), and  Loomis Sayles Core Plus Bond (NEFRX) each devoted close to 20% of assets to high-yield corporates in early 2011.

Keep Your Guard Up
High-yield corporates aren't completely insulated from Treasury yield swings, though, and that could become more apparent if the difference between junk bond and Treasury yields continues to narrow. The Wellington team that runs  Vanguard High-Yield Corporate (VWEHX) recently expressed surprise at investors' appetite for high yield at today's prices, arguing that "current yields may prove to be inadequate compensation for rising rates brought on by the combination of inflation and the end of the Fed's zero rate policy."

For their part, many high-yield managers now find themselves looking for ways to protect their portfolios against rising interest rates. For instance, Fidelity's high-yield bond funds, including  Fidelity High Income (SPHIX), have devoted a significant slug of assets to floating-rate bank loans, which are insulated from rising bond yields.

On the credit-risk front, high-yield managers also see the need for some caution. Gino Nucci, comanager of  Metropolitan West High Yield (MWHYX), notes that valuations in the CCC rated segment of the high-yield market look expensive relative to the incrementally better-quality B rated segment these days. The majority of defaults occur among CCC rated issues, and many of these companies' highly leveraged balance sheets require strong economic growth to survive.

Other managers including  T. Rowe Price High Yield's (PRHYX) Mark Vaselkiv and  Western Asset High Yield's (WAHYX) Mike Buchanan have trimmed their funds' CCC exposures recently. Mark Notkin at Fidelity Capital & Income tends to hold more of the market's lower-quality issues than most peers, but even he's trimmed that back lately. The fund's CCC stake dropped to 19% of assets at the end of 2010, down from a third a year ago. Notkin also cut the fund's exposure to highly leveraged LBOs in half from their high point. He has the flexibility to own equities in that fund, and that's where he says he's found better bargains over the past year.

Strong investor demand for high yield also allows companies to issue bonds on less bondholder-friendly terms, a trend that bears watching. The majority of high-yield issuance in the past two years was used for refinancing, but an increasing amount of new issuance is financing acquisitions, adding leverage to balance sheets. Roughly one fourth of leveraged loan issuance in 2011 has come to market without the usual covenants that afford borrowers early protection against deteriorating fundamentals. A few egregious examples of lax underwriting--such as buyout firm KKR's takeover of Del Monte Foods, which co-founder Henry Kravis extolled as "the most attractive financing (the firm) has ever done"--underscore the increasing need for careful credit selection.

Some allocation to high yield still makes sense today, especially to diversify a high-quality bond portfolio in a rising Treasury yield environment. But today's low absolute yields and limited upside hardly signal an attractive entry point. Fund investors could take a cue from increasingly cautious high-yield managers and temper their expectations. There was no better time to take credit risk than early 2009; unfortunately, those who've waited until now to get in on the action may be left to clean up the detritus.