One of the big asset allocation choices facing investors in US financial assets right now is whether to go to high-yield fixed income. Average spreads on junk blew out to 2,000 basis points over Treasuries, but over the past eight weeks, tightened to inside of 1,200 bps.
Obviously, the dramatic play has been made, and high yield has returned 19% year-to-date. But given that junk spreads' historical average is around 550bps, and have been as tight as 450bp, some portfolio managers reckon this is still an attractive asset class.
The consensus among managers of US fixed income is that high-grade credit offers the best risk-adjusted returns, not just among bonds but all asset classes, a point made in AsianInvestor's February cover story, "Credit hunch". This has not changed. But some clients are looking to add risk, and high yield is the first port of call.
America's bond markets have been bifurcated by the government response to the financial crisis. A year ago, 30% of the Lehman Aggregate Index (now the Barclays Agg) was government or government-linked debt; today this is 70%, and the Federal Reserve is snapping up mortgage-backed securities and the Federal Deposit Insurance Corporation has become a huge issuer.
"There are now two bond markets in America, one government-supported and one private," says Mark Maronella, head of US fixed income at State Street Global Advisors in Boston. Although the government sector provides safety, thanks to government programmes to buy mortgages and so on, Maronella says good returns can only be found in the private sector, including high yield. Admittedly the tightening of spreads means junk is no longer great value -- but it's still good value, he argues, and is still priced to make investors money should default rates hit 15% or more.
"We're warming to the idea that now's the time to take risk," says Michael Roberge, US investments CIO at MFS Investment Management in Boston. He says both equity and credit markets have rallied over the past two months on the basis of confidence-building measures by the government, from stress tests for banks to quantitative easing. Much of the tightening in credit spreads is because the market is confident the government can prevent a doomsday scenario.
The question is whether this signals the beginning of a cyclical recovery, and Roberge says it's too early to tell. He says if defaults hit 13% or so, junk bonds are still attractive, but if unemployment gets worse than expected and banks suffer more capital problems, then high yield is a dangerous bet. Still, he thinks now is the time to go into risky assets, and says high yield has the potential to deliver 15% annualised returns for the next three years.
Not everyone is convinced. Ben Inker, partner at GMO in Boston, says the default risk is high. While bank debt looks safer, because defaults have been priced in, he says this could change if the government changes the rules -- something it has shown a readiness to do in the case of automobile companies.
Jerry Webman, senior investment officer and director of fixed income at Oppenheimer Funds in New York, says investors should be nervous that spreads on high-grade corporates have not tightened nearly as much as those in junk. "This tells me the best companies still can't access capital, and we're not in the clear," he says, adding he expects leveraged junk bond spreads to blow out again before they tighten significantly.
The decision on high yield probably comes down to two things: investor appetite for risk (which many fund managers say is returning), and the outlook for inflation.
Kent Wosepka, director of US taxable fixed income at Standish (a unit of BNY Mellon) in Boston, explains that if you expect inflation to gradually return, then leveraged plays such as high yield can outperform. High yield names tend to be companies with leverage. Fund managers with high-yield mandates are looking for such companies with the ability to pass on future price increases; the value of their debt will be inflated away. But if the US economy spirals into a further deflationary whirlpool, and default rates turn out to be worse than predicted, then high yield is going to be a bad place to be.