(05/08/14) High Yield Bonds: More of the Same?

High yield bond funds have started the year off surprisingly well, as yields have fallen to record lows near 5%, explains Marvin Appel, editor of Systems & Forecasts.

Most high yield bond mutual funds yield even less than that, both, because of the funds’ expenses, and because mutual funds tend to stay away from the lowest grades of junk bonds, making them generally safer and lower-yielding than the full high yield bond index.

The issue is not only one of absolute yields, which are low across the spectrum of the bond market, but also of the spread between the yield you can get from junk bonds compared to the yields available from less risky types of bonds.

This is called the credit spread, with a smaller difference between junk and investment grade bonds—a smaller spread—indicating that the bond market is not as worried about default risk as when spreads are wider.

Unlike absolute yields, credit spreads are not at record lows—but they are close. Spreads are near levels that we saw from 2006-2007 and 1997-1998. Both of these occasions turned out to be major tops in the high yield market.

Historical precedent shows that, although complacency can last for months or even years, it suggests that we are in for a major correction in the high yield bond market.

I do not expect that to occur until 2016. However, until then, returns from all manner of bonds will be at levels commensurate with their current yields (to maturity), far below historical norms. In the case of high yield bond funds, I project total returns of 4%-5% per year.

In the wake of the financial crisis of 2008, high yield borrowers had a difficult time coming to market. As a result, nearly half of outstanding high yield bonds were issued just in 2012-2013.

Since those high yield borrowers—destined to default—don’t usually run into trouble until three or more years of issuing debt, barring any major economic deterioration, bondholders should be relatively safe until 2016.

Borrowers have been able to bear more debt because interest rates fell during that period. Although I do not expect interest rates to rise until late 2015 at the earliest, the relief valve of falling rates has likely been closed. Indeed, high yield borrowers virtually froze their capital expenditures in 2013.

So, with no likelihood of refinancing existing debt at better rates, high yield bonds are priced for perfection. Any deterioration in the economy or jump in inflation will take its toll, as current yields provide very little margin of safety.

Fortunately, none of these bearish developments seems imminent. With moderating growth in China, inflation under control, and slowly accelerating growth in the West, the fundamental backdrop for high yield bonds remains favorable and is expected to stay that way.

Fed tapering is a good thing, in my view, and the completion of tapering by the end of 2014 should not derail the high yield bond market. The first known danger is when the Fed starts to raise its short-term interest rate targets.

My outlook for high yield bond funds through the end of 2015 is for more of the same: low returns and low risk. However, investors should be vigilant with their high yield bond funds, as they will likely suffer at the first sign of trouble.