Is high-yield debt overpriced?

Junk bonds may offer attractive returns relative to sovereign debt, but both asset classes are at record low yields. Are investors taking sufficient note of fundamentals?
Is high-yield debt overpriced?

After a year in which investors poured money into bonds, from sovereign issues to emerging-market debt to high-yield, people are now asking if junk bonds are too expensive in light of the credit risk they pose. Some feel the answer is unquestionably "yes".

“There’s very little value in fixed income in terms of yield right now, even in the so-called high-yield space,” says Stephan Repkow, Asia CEO of private banking at Union Bancaire Privée.

Barclays' US high-yield corporate bond index broke below 6% for the first time at the start of January and stood at 5.75% on Friday. On the same day, the 10-year US Treasury yield was a little under 1.9% and 10-year German bunds below 1.6%.

“Junk bonds are not priced as junk anymore and are not giving commensurate return for the level of risk of default or credit event probability," says Repkow. "They are priced almost exclusively in terms of relative value to other securities – such as US Treasuries – or asset classes, rather than in view of their fundamental or intrinsic value.

“This is the new form of complacency in the market, as a result of the ultra-accommodative monetary policies in the US, Europe and now Japan, which we advise our clients to be very attentive to," he adds.

“Actually, equities for similar issuer risk and name are becoming more attractive as dividend policies are becoming more steady and price valuation has, by definition, more upside potential than bonds at the current yield level.”

One result of the present environment has been increased interest in lower-risk, principal-protected investments, notes Repkow, as reported last week by AsianInvestor.

Meanwhile, others are more sanguine in their outlook on high-yield bonds.

Luca Paolini, chief strategist at Pictet Asset Management, says: “The investment appeal of higher-yielding fixed-income assets such as speculative-grade corporate debt and emerging-market sovereign bonds remains strong following an acceleration in the pace of monetary easing in both the US and Japan.”

He argues that EM debt looks particularly attractive, given that the base-rate differential between developed and developing economies widened over the course of last year to 500 basis points. “This rate gap should provide strong support for EM currencies, one reason why we favour local over dollar-denominated EM debt,” says Paolini.

“Corporate high-yield bonds are attractively valued and remain an overweight,” he adds. “Spreads continue to offer investors ample compensation against the risk of default.”

Default rates in European markets are below average and are unlikely to rise by much over the medium term, argues Paolini, as many companies have managed to extend the duration of their liabilities and maintain high levels of cash on their balance sheets.

Hence Pictet AM remains overweight EM debt and high-yield bonds “as sluggish economic growth and low interest rates provide support for riskier fixed income asset classes”.

In terms of global positioning, the firm remains underweight equities and overweight cash, also due to sluggish global economic growth and the fact that earnings forecasts are “heading lower”.

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