Something’s Got to Give…Better Yield
Yields on North American government bonds are at historic lows and are also below the level of inflation, which means investors are potentially facing a negative real rate of return. Flows into high-yield investments have increased dramatically as investors clamour for vehicles with better yields. And, high yield has delivered some stellar returns during the course of the past year or so. Spreads now sit well below their long-term average of 535 basis points (in the US) and although strong balance sheets and historically low default rates might justify these narrower spreads, we could make the converse argument based on relatively weak growth rates.
T.E. Wealth clients who attended our last Speaker Series event will recall that during the “Bond Conundrum” presentation we talked about plans to research investments that could improve the yield from the fixed income component of their portfolios. Since then, we’ve spent quite a bit of time exploring the high-yield space and searching for viable investments that could be employed to acquire exposure to this segment of the fixed income market for our clients. We recently completed an internal research document that outlined some of the available options, but also contained a proviso that it might be too late to access these strategies. Remember that widely-touted investment axiom about buying low and selling high! Well, low absolute yields mean that high-yield bond prices are sitting near their all-time highs.
This is a different type of fixed income investment so clients should be aware of a couple key points:
(1) High yield is the most economically-sensitive subset of the fixed income market;
(2) High yield is typically less impacted when rates rise because of their shorter duration;
(3) High yield bonds are usually callable, which means the upside is limited somewhat; and
(4) High yield tends to exhibit stronger correlations to equities than to traditional bonds.
In addition, the return pattern of high-yield bonds tends to be rather erratic since changing credit spreads, default rates and economic conditions all have an impact on these investments. With respect to call provisions, it’s interesting to note that nearly half of the high-yield issues in the market are currently trading at or above the price at which the issuer could call away those bonds.
We are not trying to make a call on the markets; however, we feel it is imperative that we properly address the potential risks before making the decision to add high-yield exposure. While the income stream remains relatively attractive with coupons ahead of investment-grade issues, the current landscape is one that suggests that there is considerably more downside risk than upside potential from here. The marked rally in high yield is just one sign that the balance of risks has likely shifted from positive to negative. What would happen if the US fails to adequately deal with the ‘fiscal cliff’ or if conditions in Europe were to deteriorate?
With that in mind, we are exploring other options that might provide a more suitable risk-reward profile, specifically a corporate credit solution from a manager with whom we already have a strong relationship. Please be sure to speak with your T.E. Wealth consultant or investment counsellor if you wish to discuss how this investment might fit with your goals and objectives. And, in terms of managing expectations, we will likely have something more to communicate with regards to the corporate credit strategy by the end of the month.
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