There’s been a lack of confidence in the market from a number of sources, but we don’t try to control the market; we just control the companies we own. We do bottom-up research and follow the fundamentals to help us buy the best companies, because success in this asset class rests on the ability to choose the correct issues.
We see a number of factors at work that are making high-yield bonds a very attractive opportunity today:
- Today’s wide spreads, around 850 basis points over Treasuries, give the high-yield sector a significant yield advantage—not just over Treasuries, but over other bonds as well.
- Pricing inefficiencies have led to spreads that are exceptionally wide given the low default rate. The market is anticipating much higher default rates than are actually likely—both now and in the near future. The current default rate is only 1%-2%, and we don’t see defaults going above 5%-6% in the next 12-18 months, even if we gointo a recession.
- Corporate balance sheets are very healthy (unlike 2008 when leverage in the system was very high) with companies carrying high levels of cash on their books. They have refinanced much of their debt, so their debt service costs are much lower. The result is greater liquidity and low leverage in the system, leading to upward operating performance and, again, a lower risk of defaults.
- We are seeing a positive upgrade trend with upgrades exceeding downgrades at a near-record pace. This is a testament to third-party recognition of the health of issuers’ earnings and balance sheets.
While the short-term case for investing in high-yield bonds is compelling, the long-term case for always holding a portion of one’s portfolio in this asset class is also very persuasive:
- In years past, high-yield bonds have been principally associated with the traditionally volatile telecom and technology sectors. Today, however, they represent a well-diversified universe. An investment in high-yield bonds can actually help diversify rather than concentrate the bond position of a portfolio, which helps moderate overall risk.
- Over time, high-yield bonds have had a favorable risk/reward profile relative to other asset classes, providing equity-like returns with less volatility.In addition to higher coupons than other asset classes, high-yield bonds also offer capital appreciation potential. Investors’ constant need for income is likely over time to lead to increased buying of high yield bonds, which could drive prices up.