The meteoric rise of asset prices seen in 2009 was particularly evident across high yield bonds, and 2010 has witnessed another strong year for this asset class. But investors now question whether the relatively attractive yields still provide adequate compensation for the risk of a bond bubble or double-dip scenario. The many levers that affect the performance of high yield bonds may have shifted dramatically over the past two years, but their influence remains firmly in place.

Clearance Sale

Market participants recall 2008 with a shudder, as risk aversion and a rush for liquidity resulted in a wave of selling and a recalibration of acceptable downside exposure. By mid-December high yield spreads-the additional yield over U.S. Treasury securities demanded by investors-pushed past 21%. The label "junk bond" was taken literally.

The challenges that gripped the financial markets converged, fittingly, in a leveraged manner to punish high yield bonds. Weaker credits were a natural place to demand a higher return given the very real problems facing both industry and the banking system. So, high yield bond prices dropped and yields ballooned. Helping to fuel the fire, capital markets had frozen up at a time when many high yield issuers faced impending bond maturities and short-term financing needs that could push them to the brink of insolvency.

With market dysfunction extending even to money markets, default seemed a likely option for companies-if not entire industries-starved of new capital.

In addition to default itself, bond investors were rightly concerned about their recovery in the event of such default. The pricing outlook for second-hand collateral looked particularly bleak entering 2009.

Buyers Return

While many will argue over the curative, few can dispute that the capital markets experienced a Lazarus-like revival in 2009. With little tangible evidence of economic recovery, asset prices rode a wave of policy-induced liquidity. The market's rediscovery and aggressive embrace of credit risk pushed the total return of popular high yield bond indices past 60%. Lower rated CC and CCC bonds were bid up tremendously, many more than doubling in price, as the most dire of scenarios faded from view.

High yield bond defaults, however, mushroomed beyond 10% in the U.S., while skirting 14% globally. An apparent dichotomy between this reality and market sentiment was evident in 2009, as a record new issuance of high yield bonds was hungrily digested by investors.

This appetite for riskier credit instruments would prove to be profitable foresight and also underpin a fundamental strengthening of the high yield market. While defaults purged the market of the weakest credits-either through restructuring or outright terminal events-new issuance allowed the refinancing of maturing debt and further extension of other maturities.

Additional breathing room was also gained by the refinancing of senior secured debt, such as bank loans with high yield bond proceeds, thereby removing the stricter covenants attached to the more senior bank debt.

Healthy common stock issuance during 2009 also bolstered the prospects for high yield bondholders, who stand senior to equity and are mostly unconcerned with the dilutive effect of additional equity float.

Spread Too Far?

It is not unusual for a big rally year in high yield bonds to be followed by another respectable performance, and 2010 looks to do just that. Price appreciation in the high single digits has tightened spreads to the point where the high yield advantage over treasuries stands at less than one-third of 2008 peak levels.

The market appetite for new issuance this year exceeded the record set in 2009, and this before the ink on the third quarter was dry. Defaults for 2010 are estimated to come in at approximately 2%, as the flow of new capital and stronger asset pricing has extended the runway for many companies.

But what to do now? Absolute yields are below the historical average, the economy is struggling and interest rates can't stay low forever. Investors must also remember that high yield debt is a hybrid instrument with commonalities to both stocks and bonds, and comprises a very dynamic market. A closer look at the factors that drive the performance of high yield debt should provide helpful clarity.

Global and domestic high yield bond indices have an average maturity of just under seven years. While movements in government bond rates are not irrelevant to high yield investors, they are certainly less important than many believe.

High yield bonds are more likely to react in concert with the stock market, rather than exhibit a tight relationship to changing interest rates on treasury debt.

In fact, history shows that when high yield spreads exceed 500 basis points over treasuries, the relationship between the two is low or negative. Sensible concerns over the future direction of interest rates, which do indeed heavily influence the performance of investment grade bonds, should not necessarily deter high yield bond investors.