High Yield Bonds May Beat Inflation

Key Points:

• High yield bond prices are still not expensive despite yield spreads having narrowed considerably
• Historical data shows that a low yield spread does not necessarily mean that the high yield bond market cannot generate positive returns
• There is potential for capital appreciation if the debt ratings are upgraded or corporate earnings are improved
• Yield spreads of emerging market bonds, Asian bonds and investment-grade corporate bonds have also narrowed sharply to below their historical mean
• With low spread levels in all of the fixed income classes, investors should focus on the yields rather than the potential capital gains
• Under a negative real interest rate environment, high yield bonds may beat inflation

High yield corporate bonds, our favourite bond class in 2010 and 2011, was the strongest performing fixed income sector in the first quarter of 2011. The sector surged over 3.9% year-to-date as at 31 March 2011 (in USD terms), outperforming the majority of the equity markets under our coverage. Yields in the sector, as represented by the widely-tracked BofA Merrill Lynch High Yield Master II index, have hit a record low level of 6.8% on 18 February 2011. This is lower than the previous record-low of 6.81% in December 2004. As a rule of thumb, the higher the price of the bond, the lower the resulting yields.

According to Lipper, as at 11 March 2011, the purchase of high yield bond funds amounted to US$ 32 billion in 2009, US$ 14 billion in 2010 and US$ 6.1 billion year-to-date. It was the 14th consecutive week of net inflows. The demand for high yield bonds has been robust since 2009 as investors want to take advantage of low interest rates to receive the attractive yields and potential capital gains. However, the category suffered a temporary setback with outflows in late March as some investors have started to take profits. In this article, we explain why investors should not do so at this moment. In a low interest rate environment, the investment value of high yield bonds is still attractive given that it offers higher yields compared with other bonds.

LIMITED ROOM FOR THE NARROWING OF SPREADs

Chart 1: Yield Spread Have Narrowed Sharply

For most investors, there are concerns about the limited room for spreads to narrow further. As shown in Chart 1, yield spreads between high yield bonds and US Treasuries have already narrowed considerably. The current yield spread (340 bps as at 21 April 2011) falls in the range during the strong economic upturn (between 250 to 400 bps), but still slightly wider than the all-time tight level of 250 bps in May 2007. With such a low spread, investors doubt whether high yield bonds can deliver more returns this year.

To answer this, firstly it is important to examine whether the current spreads implied default rate (a forward looking default rate based on the market prices of traded bonds and the recovery rate) is still reasonable. For many bond investors, the key concern is whether the premium offered by high yield can compensate for the potential default risk. According to the Moody’s Investor Service, the global speculative-grade default rate was at 2.6% in the first quarter of 2011, down from 3.2% in the fourth quarter of 2010 and 10% at the end of 2009. The rating agency projects that the global speculative-grade default will drop further to 1.5% at the end of 2011.

As at the 21 April 2011, the spread implied default rate was 1.9% (see Chart 2) as compared to the estimated default rate of 1.5% by end of this year. This indicates that the risk premium currently offered by high yield bonds is adequate to compensate for the potential default risk, and it implies that high yield bonds are not expensive. However, investors should note that it is unrealistic to expect the high yield bonds to deliver the same magnitude of returns seen over the past two years.

Chart 2

FAVOURABLE ECONOMIC ENVIRONMENT FOR HIGH YIELD BONDS

Undeniably, there is limited room for the spreads of high yield bond to tighten. However, based on the historical data, the current low yield spreads do not necessarily mean that the market cannot generate positive returns. There is potential for capital appreciation if the debt ratings are upgraded or corporate earnings are improved.

High yield bonds typically perform well during the period of economic expansion. The reason is that corporate earnings are boosted when the economy is on its upward momentum. The improvement in earnings and balance sheets would drive down the default rates and lead the rating agencies to upgrade the credit ratings. Yield spreads between high yield bonds and US Treasuries narrow during periods of economic prosperity as investors require less compensation (a lower risk premium) for the lower perceived default risk in the market.

Over the past 23 years, high yield bonds have delivered positive returns in 18 years (see Chart 3). High yield bonds have also performed impressively during periods of tight spreads. The exceptions were in 1990, 1994, 2000, 2002 and 2008. The 1990 savings and loan crisis and the 2008 subprime crisis led to a credit crunch as the rising non-performing loans curtailed the banks’ lending ability. Hence, the banks became less willing to lend due to increased counterparty risks and as a result, many companies were unable to access credit. High yield bonds were sold off and yields rose sharply. In 1994, all bond classes suffered a loss due to the pre-emptive rate hike in 1994 by the Fed to tame inflation. In 2000 and 2002, credit quality in the sector deteriorated due to the large increase in the high yield bond issuance over the previous years. Investors required higher yields to compensate for the higher potential default rates.

The foundation for sustainable growth in the global economy has strengthened over the past year. In particular, the US economy has sustained a strong upside momentum. The 2010 GDP report highlights broad-based positives across both investment and consumption, with the latter showing significant strength. This provides strong support for the US corporate earnings in 2011. According to the market consensus, the overall earnings of the US-listed companies will hit a new high in 2011. Thus, we expect default rates will continue to drop this year. The favourable economic and corporate conditions point to a benign credit environment which will continue to benefit high yield bonds.

Chart 3: Performance VS Spreads

Focussing on yields rather than capital appreciation

In fact, high yield bond is not the only fixed income class experiencing significant spread tightening. Yield spreads of emerging market bonds, Asian bonds and investment-grade corporate bonds have also narrowed sharply to below their historical mean (see Chart 4 and 5). For example, yield spreads on EMBI Global Diversified Index (EM USD Bond) and GBI-EM Diversified Index (EM Local Bond) have dropped to 2.6% and 6.8%, below their past 10-year average of 4.7% and 7.1% (as at 21 April 2011).

Chart 4: Yield Spreads on Emerging Market Bonds (Local Currency and USD)

Chart 5: Yield Spreads on US Investment-Grade Corporate Bonds and Asian Bonds

This shouldn’t come as a big surprise as investors’ risk appetite has improved substantially since the yield spreads widened to record highs in October 2008 (due to the credit crunch and ensuing global financial crisis), thanks to the sustainable improvement seen in the economy. With tight spreads in all of the fixed income classes, investors should focus on the yields rather than the potential capital gains (from further spread tightening).

Returns for high yield bonds are generated by two components, namely interest income (yield) and capital appreciation. While capital appreciation was the major force behind the exceptionally strong performance over the past two years, we believe interest income will be the primary component of high yield bond returns going forward. In fact, interest income has been the larger component of total returns for high yield bonds over the long term. The interest component generates a steady stream of income based on the stated coupon of the bond.

The investment value of high yield bonds is still attractive given that it offers higher yields compared with other bonds like developed sovereign bonds and investment grade bonds. As at 21 April 2011, the yield offered by high yield corporate bond was at 6.8%, higher than that offered by other fixed income classes (see table 1). High coupon income coupled with a period of relatively stable spreads would provide a stable contribution to portfolio performance, while under a low yield environment, the hunt for better yields should result in strong demand for the asset class, placing a floor on high yield bond prices and thus providing some stability.

high yield bonds may beat inflation

Low yields coupled with moderate levels of inflation have resulted in a negative real interest rate environment, with most fixed income classes unable to outperform inflation. In Singapore, inflation was 4.5% year-on-year in April, and few fixed income classes yield enough to beat this (the 20-year Singapore Government Bond had a yield of just 2.82%, as at 24 May 2011). High yield bonds are a notable exception, and investors who want to beat inflation may wish to consider an investment in this highest-yielding segment of the bond market.

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