Manager Tim Rabe thinks junk bonds will return about 5% in 2005.
Tim Rabe, manager of the Delaware High-Yield
Opportunities Fund, believes that this year, with concerns about rising
interest rates widespread and yield spreads so tight, high-yield bond
returns won't measure up to the appetizing levels investors saw in 2003
and 2004. "There is not a lot of room for capital appreciation, and
most returns in 2005 will come from income," he cautions. "I anticipate
that the high-yield market will deliver returns in the 5% to 6% range
this year."
Despite that warning, he believes that improving
balance sheets and the underpinning of solid economic growth have kept
the high-yield market in "pretty decent" shape for now, and that
high-yield bonds present a worthwhile alternative to other investments.
"Even though below-investment-grade bond yields aren't that attractive
on a historic basis, I believe they are still a good alternative to the
high multiples of the equity markets and low Treasury yields," he says.
"A 7.5% coupon looks awfully good compared to what's out there. I think
high-yield bonds will outperform investment-grade credits in 2005."
At this point, the race to the year-end finish line
is a tight one. At the beginning of August, high-yield bond funds had a
year-to-date total return of 1.93%, compared with 2.37% for long
government bond funds, according to Morningstar. Over the last year,
the two types of funds have returned 9.61% and 8.10%, respectively.
This year's muted performance for the sector beats
the troubled economic climate of 2001 and 2002, when issuers had
trouble paying their coupons, default rates rose and the high-yield
market sank. The economic recovery in 2003 and 2004 helped junk bonds
bounce back, with high-yield funds delivering returns of 24% and 9.8%,
respectively, for those years. The rally left junk bond yields closer
to Treasury bond yields than they had been in a long time. Early in the
year, the spread between the Merrill Lynch High Yield Master II Index
over comparable Treasuries stood at around three percentage points,
well below historical norms and much narrower than the yawning gap of
roughly ten percentage points in 2002.
Despite some market setbacks this year, junk bonds
managed to bounce back and yield spreads remained tight through the
summer. At the beginning of August, when the ten-year Treasury yield
was 4.28%, the Merrill Lynch Corporate Master Index of investment grade
bonds was yielding 5.12%, while the Merrill Lynch High Yield Master II
Index yield was 7.45%.
Low default rates, which fell from a high of 10.9%
in January 2002 to a little over 2% today, have aided the high-yield
market. Default rates for speculative-grade credits could rise by the
end of the year but should remain modest from a historical perspective,
predicts Standard & Poor's. The rating agency's credit upgrades to
investment-grade status in 2005 numbered 34 through July 18, compared
with 23 downgrades to a below-investment-grade rating during the same
period.
The market also has rebounded from the May credit
downgrade of General Motors' low-investment-grade status to double B,
the highest speculative grade. In late March and early April,
high-yield bond investors suffered the double whammy of a spike in
interest rates and concerns that an influx of downgraded GM paper would
flood the market and drive prices down.
Neither event materialized. Although short-term
interest rates went up, long-term rates remained stable. And investors
managed to digest the 7% increase in the dollar amount of debt that GM
added to the high-yield market. In the three months ended July 31,
high-yield funds rallied to return an average of 4.77%, according to
Morningstar.
But the prospect of rising rates presents more of a
threat to junk bond prices than it has in the past. Usually, high-yield
bonds are much less sensitive to interest rate movements and more
sensitive to the stock market than are investment-grade securities.
With the yield spread to Treasuries so tight, however, high-yield bonds
have started to respond more like their more upscale brethren to
interest rate fluctuation. "As long as yield spreads are tight, prices
of high-yield bonds will be more sensitive to moves in the Treasury
market than they otherwise would be," notes Rabe.
In a worst-case scenario, he says, a flight to
safety could spark a high-yield sell-off even as Treasury securities
rally. At the same time, the erosion of the yield cushion could make
high-yield bonds more susceptible to a downturn in the equity markets
than they have been in the past. Despite those risks, Rabe thinks
high-yield bonds have an advantage over stocks because their returns
are not as dependent on earnings growth. "The high-yield market doesn't
need the world to grow," he says, "It just needs to generate enough
cash to pay the interest on its debt."
Another concern to investors is the potential for
default rates to rise this year, particularly if the economy slows
down. Credit downgrades exceeded upgrades in the second quarter,
according to S&P. And while there have been 50% more "rising stars"
this year than during the same time frame in 2004, the number of
"fallen angels" increased as well.
Rabe acknowledges an increase in the number of
issuers at the lower quality end of the junk bond spectrum over the
last year, but maintains, "This is not a return to the speculative
years of 1998 through 2000, when most triple C issuers were emerging
telecoms with no cash. Many lower-rated companies today are highly
leveraged but have positive cash flow characteristics as well. Their
rating reflects how private equity companies driving leveraged buyouts
are choosing to capitalize."
Perhaps the biggest factor tipping the scales in
favor of high-yield bonds is the fundamental strength of the underlying
issuers, Rabe says. "There are very few companies out there missing
their earnings targets or credit metrics," he says. "Out of 140 to 150
names we have in our portfolio, only two have not exceeded earnings
expectations."
The fact that companies with speculative ratings
have managed to hold their own in a difficult environment testifies to
their resiliency, he adds. "The high-yield market has managed to
weather difficult operating environments, high oil prices and volatile
commodities markets this year," he says. "The prospects for these
companies should remain stable or improve." At the same time, the
"global reach for yield," as well as increased participation in the
high-yield market by pension funds and other institutional investors
seeking to shore up portfolio yields, will continue to support demand.
Rabe, who has managed the fund since 2002, has been
tailoring the fund's investment strategy to mitigate the impact of a
rise in interest rates and avoid companies that could be vulnerable to
a business slowdown. "In this environment the key is avoiding pockets
of disruption," he believes.
To identify potential trouble spots as well as
opportunities, Rabe analyzes macroeconomic factors to identify
undervalued industries with expected strong short-term performance. He
also tries to forecast key top-line drivers such as free cash flow,
interest rate coverage and debt coverage.
With the uncertain outlook for auto sales, he cites
auto parts suppliers as a possible problem area for the high-yield
market. On the other hand, paper manufacturers like fund holding
Abitibi Consolidated stand to benefit from capacity shutdowns by larger
companies that have helped bring supply into line with demand. Rabe
bought the company's bonds about two years ago after they sank to
"fallen angel" status following a rating downgrade.
At 3.8 years, the portfolio's average effective
duration is on the shorter side for the fund, reflecting Rabe's concern
about rising interest rates. He uses yield-to-call bonds, which are
likely to be refinanced by the issuer within three to 18 months, to
shorten duration and limit interest rate risk. Many of these bonds were
issued several years ago with five-year call protection, at a time when
yields were higher than they are today. Now that the call date is
approaching, the issuer is in a position to redeem or repurchase the
bonds early at lower rates. In the meantime, these high-coupon
securities have volatility characteristics similar to shorter-term
paper. Rabe says he also attempts to control interest rate risk by
overweighting the fund in single B names, which are less tied to the
fluctuations of the Treasury market than issues at the higher-quality
end of the junk bond spectrum.