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High-Yield Bonds at a Crossroads

Three high-yield bond managers discuss the current state of the high-yield market and the role high yield should play in an investor's portfolio.

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This analyst blog is part of our coverage of the 2016 Morningstar Investment Conference. 

2015 was a challenging environment for high-yield bond funds. The high-yield bond Morningstar Category fell 5% last year amid falling commodities prices. Adding to the category's woes was the highly publicized closure of Third Avenue Focused Credit. But the high-yield bond category has staged a bit of a comeback this year, gaining 6% for the year to date. Given this backdrop, investors may wonder, what is the current state of the high-yield market? Is high yield overvalued? How should an individual investor think about using a high-yield fund in his portfolio?

In the panel discussion "High-Yield Bonds at a Crossroads" led by Sumit Desai at the Morningstar Investment Conference, panelists Fred Hoff, manager of  Fidelity High Income (SPHIX), Michael Hong of Wellington, who runs  Vanguard High-Yield Corporate (VWEHX), and Mark Vaselkiv, who runs  T. Rowe Price High Yield (PRHYX), weighed in on these questions.

All three panelists agreed that a long-term horizon was key to getting the full income and return benefits of the asset class. 

"Trying to time the high-yield market is a loser's game," Vaselkiv said. Vaselkiv also made the point that the high-yield space contains "permanent residents and tourists," and when the short-term-focused investors get spooked and leave, it creates buying opportunities for longer-term-focused investors. (That said, it also hurts longer-term investors in funds to have frequent traders come in and out of the mutual fund.) 

Fred Hoff likened it to arbitraging against a short-term mentality. 

"If ETFs get redeemed for $3 billion, we'll buy those securities," he said.

The panelists also opined that the recent Moody's downgrade of dozens of oil companies, in the face of deteriorating prices for oil, was done close to the bottom of the cycle. The net effect of buying these "fallen angel" bonds was a credit-quality upgrade for the panelists' portfolios (though it should be noted that all three panelists tend to focus on higher-quality credits in the high-yield market in running their funds). 

Hoff made the point that going forward, the impact of energy will be "less exciting"; the number of at-risk high-yield companies is actually down from a few years ago. (The energy sector remains the largest constituent of the high-yield market, making up 13% of the Bank of America Merrill Lynch High Yield Master II Index.) Vaselkiv agreed, adding that if you do your forecasting with conservative assumptions, you'll quickly discover which companies will survive if oil trades back down (namely, those with proven access to capital and sturdy balance sheets).

When asked where we are in the credit cycle, Hoff said  last year was a "healthy reset" for the credit cycle; it reset risk expectations for the asset class. 

Liquidity is also a topic that the panelists addressed. Specifically, how do you think about liquidity, and how do you manage your funds around liquidity? The panelists all seemed to agree that liquidity is always there, at a price. Hong pointed out that the Vanguard High Yield Fund holds a significant amount of cashlike instruments in order to ensure sufficient liquidity.

Liquidity is a double-edged sword, pointed out Vaselkiv, in that buying can be as difficult as selling in the secondary market, particularly in the past five years. 

When responding to the question "What is your outlook?" Hoff said we've had a nice run because of greater commodity prices, but the market is still an attractive place to be. At more than 4 times the yield of Treasuries, on a spread basis high yield is attractive in Hoff's opinion. 

Vaselkiv said even if a downturn were to happen in the near future, the asset class is very resilient, and secular demand for income from institutional investors creates something of a floor for the asset class. 

"[High yield is a] powerful wealth creator that demands and requires a long-term horizon," he said.

Karen Wallace does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.