We do think defaults will pick up, but we expect that will be isolated to companies that are in a cyclical downturn or that can’t support their balance sheets.
—James Keenan, managing director and head of leveraged finance, BlackRock
Think high yield bonds are too risky? They pose heightened credit risk relative to their higher-quality fixed income counterparts, but risk comes in many forms. Traditional higher-quality, “safe-haven” bonds pose their own risks in the current environment. Given their record low yields, US Treasury securities may well offer negative real returns after inflation and, along with other higher-quality bonds, are more exposed to price loss when interest rates do eventually rise. High yield offers an upper hand on these fronts for these reasons:
• Although the economy is slow, we find that most companies remain in excellent health, which makes high yield bonds attractive given expectations for
continued low defaults.
• High yield bonds historically generate above-average income, evidenced today by a more than 600-basis point spread over Treasuries.
• High yield bonds have produced equity-like returns, but with roughly half the historical volatility of the equity market.
• High yield and bank loans reside between higher quality fixed income and equities in their risk and return characteristics and, we believe, should be
a key component of investment portfolios today.
High yield and loans are very attractively priced today. The default rate on high yield bonds is around 2% and for loans it’s under 1%. We do think defaults will pick up, but we expect that will be isolated to companies that are in a cyclical downturn or that can’t support their balance sheets. Most of those assets are already priced accordingly. The market, however, is pricing in much higher defaults than we believe we’re likely to see. At today’s levels, markets are pricing in 5.5% to 6% defaults at a target return of 300 basis points over Treasuries, and the break-even default rate is over 13%.
So, bottom line: high yield is a value today in terms of the income you’re getting for the risk you’re assuming. Consider also that out of the $2 trillion market in high yield
and loans, we only have about $47 billion maturing in 2012, so there’s not a lot of refinancing risk. Demand for higher-yielding assets is strong right when supply is looking to be tight, so that is creating a good technical backdrop as well, which should support market prices.