Market Memo: High yield may be the best game in bond town
There’s no doubt 2012 was another good year for high-yield bonds. The benchmark index, Barclays U.S. Corporate High Yield 2% Issuer Capped, returned 15.78% on the year, capping a strong four-year run that saw the index return 22.03% annually from the end of 2008 through 2012.
Don’t look for a repeat performance this year. That said, when it comes to fixed-income products, we believe high yield may still be the best game in town in 2013. Investors with rationale expectations could see potential returns in the 6% to 8.5% range this year, a respectable showing given the low-rate, low-yield environment enveloping much of the bond world.
Driving this outlook are the same forces that have benefitted high yield since 2008: Continued low default rates (we expect them to remain well below historical averages); tightening spreads (the gap between yields on high-yield bonds and comparable maturity Treasury securities is roughly at its historical median level); positive albeit sluggish economic growth (improvements in housing and autos, resilient consumers, the half-loaf fiscal cliff solution and a stabilizing Chinese economy have taken recession risk off the table); and solid earnings and corporate credit (profit growth is tougher but credit measures remain very strong).
6% in a subpar 5% world still looks pretty good
Supply-and-demand fundamentals also are attractive—net new issuance is low and the global search for yield is fueling a flood of investor interest in high-yield bonds. To be sure, the upside is limited. The average yield on the benchmark has fallen below 6%, limiting both the appeal to yield-hungry investors and also limiting the absolute total return potential. However, relative to other fixed-income instruments (which are also close to all-time low absolute yields), 6% is still pretty attractive. It’s extremely difficult to find any other fixed income product offering yields above 5%.
As we’ve also noted before, during spread-tightening cycles, yield spreads typically bottom well below median levels, which would suggest more tightening to come. For reference, in the last cycle, month-end yield spreads on the Credit Suisse High Yield Index bottomed at 271 basis points on May 31, 2007, vs. the 554 basis-point spread at Dec. 31, 2012. Remember, spreads can tighten as a result of two forces: high-yield prices moving higher (pushing down yields), or U.S. Treasury rates moving higher (which is somewhat depending on what the Fed does and on inflation expectations, which the Fed is purposely seeking to nudge up). We think 2013 spreads will be determined by a combination of the two, and just how each side plays out will determine where returns fall in our 6-to-8.5% target range for 2013.
The bottom line: if you’re looking for high-yield to perform this year as it has the past several years, you are going to be disappointed. But if you adjust your expectations, we believe you may just find that high-yield offers both the best absolute and relative value in the yield-challenged fixed-income world.