The high-yield market has been going great guns this year. The indexes are posting returns of about 8%, and the average high-yield mutual fund generated 9.2% so far this year, according to data from Lipper.
This is of course lower than last year’s record 57%. But that was obviously unsustainable since it was largely due to the fact that 2008 was so bad.
Indeed, we all knew that it was unsustainable earlier this year, but even the ratcheted-down expectations then were probably still too rosy. Now there’s a major caveat for those interested in high yield: a slower-than-expected recovery of the economy.
Earlier this year, it seemed as if we’d turned a corner. Economic growth predictions, while not stellar, were in the 2% to 3% range, not as good as China or India, certainly, but good enough for the high-yield market. As long as GDP stays above 1.5% or so, the spectacle of widespread defaults (the nightmare for high-yield buyers) remains a low probability.
Guess what? In the second quarter, the annualized GDP rate was 1.6%. And most prognosticators among us are now calling for a long, slow recovery. That makes high-yield a much harder game all of a sudden. And it wasn’t an easy game before.
A lot of clients will be turned off simply by the risks inherent in high-yield, not to mention the moniker “junk bonds.” But for those who are asking about the possibilities, the best solution is a fund. According to Lipper’s data, some of the better performers over the year were Fidelity Real Estate High Income, 19,6% year-to-date [FRIFX]; John Hancock II High Income Fund, 14.9% [JIHDX]; and John Hancock III Core High Yield [JYIIX].
But even with a fund, you should make sure your client understands the basics of the high-yield market.
For one thing, it’s unlike other fixed-income markets, in that the interest rate isn’t the main driver; it’s more akin to the stock market, as each company is its own story that needs to be analyzed. For another thing, it’s risky. Bonds are indeed higher in a company’s capital structure than equity, so bondholders are safer than shareholders of any given company. (So if your client wants to buy the shares of a “junk” company, then, yes, he’s safer with the bonds instead.) But as a whole, this market is still made up of relatively small, risky companies.
And talk to your clients about the notion of “mission creep” by some funds. That is, while some funds have strict in-house rules that they must be invested in high-yield bonds, some others have more latitude to invest in other things like convertibles. This can boost returns in good times, but it can also make things more complicated if your client likes to keep their portfolios strictly segmented.
More to the point, though, those small, risky companies making up the high-yield market are now facing the likelihood of a tougher economy in the near future. So their growth plans they had just six months ago may warrant a second look if they, say, used a 3 for expected economic growth in their valuation equations.
To be sure, many of them will be just fine. And many will generate more than enough cash flow to make their coupon payments even in a long, slow recovery. So there is definitely a place for this market in your client’s portfolio. But it requires more time than other investments to really understand the dynamics of the market, and how the funds can best be used within a complete portfolio. Especially in a low-growth economy.