The recent surge in popularity of high-yield bonds has left Andrew Feltus both encouraged and concerned.
On the one hand, the 42-year-old manager of the Pioneer High Yield Global Fund believes the record inflows since the beginning of 2012 into mutual funds and ETFs that specialize in so-called "junk" bonds has successfully raised the profile of an often-ignored corner of the market. The strong demand, propelled by a migration of yield-starved investors into riskier but higher-yielding assets, has also helped generate returns well above other types of fixed-income securities in recent months.
At the same time, however, the manager sees cause for concern when hordes of investors who may not understand the risk and volatility associated with the asset class pile in.
"The short-term markets are a voting machine, and right now they're saying high-yield bonds are the place to be," he says. "I just worry that a certain percentage of the money flowing into high-yield funds will panic when something bad happens. When people chase returns, it never ends well."
Although the eventual fate of the high-yield bond market remains to be seen, its resurgence since last year has been sharp and swift. The bonds started 2011 on a high note, when strong demand boosted prices. But as the year wore on and concerns about the economy prompted investors to flee riskier assets, junk bond spreads widened from around 500 basis points over Treasurys in May to over 800 basis points in November. Still, the group managed to end the year up about 5%, beating the S&P 500 index's total return by 3 percentage points but lagging intermediate-term Treasurys by about 1.5 percentage points.
Since then, a renewed confidence in the U.S. economy and European Central Bank efforts to prop up Greece's economy and add liquidity to the system have led investors back into more speculative fare. With renewed demand, the yield advantage of high-yielding junk bonds over Treasurys had narrowed to around 600 basis points by mid-March of this year.
At this point, Feltus sees a number of signs supporting a healthy high-yield bond market, at least through 2012. "Default rates on corporate debt are about 2% now, compared to a historic average of 5%," he says. "The U.S. economy is in pretty good shape, and Europe is doing better than many people expected. The European Central Bank is not tightening its monetary policy. And there is nothing arguing for an increase in default rates."
But there are some looming problems. In the latter half of 2011, 7% of corporate bonds experienced credit downgrades by rating agencies, while only 1.9% snagged upgrades, according to Fitch Ratings.
Most of the downgrades were attributable to bonds issued by banks. Fitch projects that the overall corporate default rate will tick up to the 2.5% to 3% range by the end of the year.
Feltus worries about a looming "fiscal cliff" in 2013, when higher tax rates and government spending cuts could kick in. If that happens and economic growth stalls, junk bonds and other riskier assets like stocks that get a push from economic growth could also stall. Political uncertainty is also running high. "There are about 60 different elections going on around the world, and any surprises could add to market volatility," he says.
While the Fed seems to be keeping interest rates in check to keep the economic recovery from stalling out, Feltus cautions that rates could rise by next year. That environment would hurt rate-sensitive Treasurys more than lower-rated corporate bonds, which blend the performance characteristics of the bond and stock markets. But junk bonds would still feel the spillover effect from rising rates as their yields become less attractive relative to Treasurys.
Feltus is taking a cautiously optimistic view after the recent junk bond bull market. "Given current valuation and risks, I think the easy money in high-yield bonds has already been made," he says. "But I also believe that relative to other fixed-income securities, they are still quite attractive." High-yield bonds get support on the downside from their attractive coupons, and the returns "could average about 5% over the next five years," he says, while Treasurys could lose money over the next couple of years.