The Product Guru: It’s High Times in High-Yield

The high-yield market had enormous growth last year, posting a record 57% return. Granted, that was largely due to the fact that 2008 was so bad, but still, 57% is 57% for investors who were brave enough to be in the market for the full year.

But as things have stabilized, the returns won’t be as easy this year. So the ever-present question looms: How does high-yield look going forward?

And the answer, according to those in the market: Pretty good. High-yield stands at an interesting crossroad that can offer investors a decent return while also a providing a healthy safety net that they can’t get from stocks.

People in the market are expecting somewhere between 9% and 11% from the market this year with the majority of that coming from coupons payments, and a little bit coming from price appreciation.

The issuers in the high-yield market are benefiting from the improving economy. And while there are lingering doubts on how strong this recovery really is (especially on the jobs issue), it’s good enough that these companies are making their bond payments.

Economic growth is expected to be about 3% this year. And while that’s not great compared to historic norms of 3.3%, it’s good enough to assuage bond investors. Aside from the possibility that 3% growth might be the new macro benchmark in general, it far surpasses the panic threshold where you see wholesale defaults. That’s about 1.5%.

Many high-yield issuers are generating enough cash and posting high enough earnings that they’re getting upgrades from the rating agencies.

High-yield is closer to stocks than other fixed income in the way it behaves. That is, instead of changes in monetary policy being all-important, the market is driven, like stocks, by the health of the economy and the quality of the issuers.

And the fact is, those measures are pretty good right now. According to Lord Abbett’s research, there were 88 downgrades in the second half of 2009, compared to 142 upgrades. And that trend continued in 2010, with the first two months seeing 39 downgrades to 65 upgrades. Compare that to the first quarter of 2009: 283 downgrades to just 25 upgrades.

Zane Brown, partner and fixed income strategist at Lord Abbett, said that this is just one indication of the improved quality of the market. “It’s less risky than last year," he said.

The new attraction for high-yield investments has certainly not been lost on issuers. Brown said that some $60 billion in new issues came to market in the first quarter, a record amount.

Martin Fridson, the chief executive officer of Fridson Investment Advisors, said that the high-yield market’s performance correlates to expectations of the default rate about two quarters hence. And that figure, he estimates, will be about 3.8%.

Other estimates for defaults are even lower, but whatever estimate is used, expectations are in the low single digits, a major drop from the first quarter of last year when defaults were 16.9% annualized.

The second big draw of high-yield is the safety. Even though these are the risky companies (sub-investment-grade, BB and lower, junk bonds, whatever you want to call them), the fact is, their bonds are still safer than equities because of their place in the capital structure.

Indeed, while investors have pulled cash out of money markets and looked around for a little better return, much of that has gone into high yield instead of equities, Brown said. “People are tired or earning one percent,” he said.

According to AMG Data, high-yield has seen cash inflows in each of the past five week, totaling $2.7 billion.

So as clients grow less risk averse than they were a year ago, but still want a level of safety in their portfolio, consider the high-yield market.

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