Market Views: Are junk bonds worth the risk now?

Investors hunting for higher-yield fixed income might have better luck with Asian high-yield debt. But what are the caveats?
Market Views: Are junk bonds worth the risk now?

While interest rate cuts by leading central banks have kept their respective economies afloat, they have added substantial pressure on bond returns, pushing investors to fish for higher yields from riskier assets.

The US Federal Reserve's policy rate now stands at 1.75% to 2%, while yields on three-year and 30-year US Treasuries were trading at 1.58% and 2.25%, respectively, as of Wednesday's close.

With corporate credit spreads  at or near record lows and yields at rock bottom, some investors are being tempted into junk bonds, to the extent their mandates allow it. 

Speaking at FundForum Asia last week, Paul Carrett, group chief investment officer at Hong Kong-based insurer FWD, said Asian high-yield bonds could help "keep the aggregate yield up". Others were also optimistic about these assets.

So, amid this low-rate, late-cycle environment, are Asian junk bonds the answer? Or is there still value to be had from US or European high yield? 

Five experts from across Asia, Europe and the US offer their views on the sector below.

The following extracts have been edited for brevity and clarity.

Stephen Chang, portfolio manager for Asia 
Pimco (Hong Kong)

As global growth continues to slow and fixed income yields continue to fall, we believe the market has entered into a “window of weakness” – a period characterised by low growth and high uncertainty. There are reasons for investors to exercise caution today.

Stephen Chang

Specifically, we remain cautious on generic corporate credit exposure, though we are quite constructive on Asian dollar high-yield bonds. [These offer] compelling relative value, improving technical conditions and plentiful alpha opportunities across a growing and diverse opportunity set.

We view Asian high-yield as a lower-volatility, higher-quality alternative to generic high-yield or broad emerging markets exposure. Importantly, [it] presents nearly 200 basis points of premium relative to US high-yield credit, with an attractive yield-to-worst of 7.23%, as of September 30.

Improving technicals should help drive performance, with active primary market issuance balanced by strong investor bids for yield, coupled with robust flows into Asian high-yield mutual funds.

We believe the Asian high-yield market is rife with opportunity for active fixed income managers that are able to navigate changing market dynamics, while maintaining a careful focus on risk management and bottom-up credit selection.

Meanwhile, managers’ scale and depth of resources committed to Asian credit markets, and identification of growth opportunities poised to outperform, will go a long way towards deciding winners and losers over this cyclical “window of weakness”.

Jay Kloepfer, head of capital markets research
David Zee, fixed income specialist
Callan (San Francisco)

High yield late in the cycle may seem like a bad idea, but investors’ need for yield in the face of falling rates for government bonds is strong.

Jay Kloepfer

The [US] credit market is still appealing. The higher coupon-clipping aspect of spread has led to superior returns over time. High-yield fundamentals broadly speaking remain stable to slightly deteriorating, but much better than just a few years ago, when the collapse in oil prices hit energy, and the entire HY universe traded down. The caution we hear from credit managers currently is you really have to pick your spots.

Long-term appeal aside, few managers are currently increasing their exposure to [US] high yield, and in fact many are trying to rotate out of the sector; the sentiment is that now is not a good time to initiate positions. Managers focused on credit are moving up in quality, in anticipation of an economic downturn and widening spreads, saving dry powder for a plunge back into distressed opportunities.

US HY spreads are tight (the option-adjusted spread was 375 basis points, by the Bloomberg Barclays High Yield Index on October 23), but not at their all-time low (233bp as of May 23, 2007). But sentiment suggests there will be widening in the next six to 18 months.

The tightening in HY has thus far been concentrated in the BB and single B-rated segments, leaving CCC spreads wider. Both BB and B segments tightened 151bp year-to-date, currently at 203bp and 380bp, respectively, while CCC compressed 61bp to end at 928bp.

Dorian Carrell, multi-asset fund manager 
Schroders (London)

From a historical perspective, high-yield bonds, across both developed and emerging markets, are clearly fully valued. Yields of 5.5% for the global universe and spreads of 365 basis points are near their post [2008] global financial crisis lows. On a strategic basis, therefore, high-yield bonds do not represent a compelling stand-alone valuation opportunity.

Dorian Carrell

That said, the fundamental and liquidity backdrop has changed materially over recent years, slightly increasing the asset classes’ tactical appeal. Looking at fundamentals, while leverage has nearly doubled to cyclical highs, this has been partially offset by unusually low interest rates. Put simply, sustained low rates have allowed high-yield corporates to borrow larger amounts more easily and at a considerably lower cost than before.

Looking forward, key risks relate to the future path of earnings and the ongoing availability and cost of finance. Given that US interest rates are predicted to fall, issuers’ cost of debt should, in the very near term, also decline. With leverage this high, however, corporates are unusually vulnerable. Any deterioration in earnings will likely lead to an increase in projected defaults (which are already picking up from very low levels), placing pressure on both ratings and spreads.

Finally, in terms of market dynamics, the ongoing search for yield should continue to drive flows into both the high-yield market and into leveraged loans. Given the market’s size and unusually rapid growth rate, we believe underwriting standards in leveraged loans are, perhaps for the first time, a key area for investors to monitor.

Charles de Quinsonas, deputy manager of the emerging markets bond strategy
M&G Investments

Charles de Quinsonas
Charles de Quinsonas

Over the past 18 months we have gradually increased our exposure to Asian high yield, in particular in China, due to valuations becoming attractive.

The area in which we have increased exposure primarily is China property, while we remain cautious on China industrial high-yield, which is much more vulnerable to an economic slowdown. 

The China property market is in decent shape and comprises approximately 50% of the Asian high-yield market. The sector has much better fundamentals than during the 2014/2015 period, while structural demand continues to be supported by urbanisation.

Elsewhere in Asia, we are very underweight Indonesian high-yield on valuations, which look very expensive. In India, we favour mid BB-rated issues but remain very cautious on the lower credit quality B-rated India names.

David Mihalick, head of US public fixed income

While the search for yield is nothing new, it has certainly intensified in recent months as low and even negative-yielding debt continues to dominate the investment landscape. But for investors who may normally turn to higher-yielding assets, such as high-yield bonds and loans, a number of potential concerns – slowing economic growth, the elongated credit cycle, and an increase in defaults – remain top of mind.

One big question, in particular, is around valuations – and whether spreads, at current levels, are compensating investors for the amount of default risk they’re assuming. The short answer, in our view, is 'yes' – based on a few key considerations: market and issuer fundamentals; supply/demand dynamics; and historical default and recovery rates.

Defaults – the biggest potential risk for [US] high-yield investors – continue to hover around 3%, slightly below long-term historical averages.

While an increase in defaults across more challenged sectors – energy and retail, namely – has contributed to a slight uptick in overall defaults this year, we do not expect to see a widespread or material increase in defaults in the near term.

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