Their name is an oxymoron, but high-quality junk bonds themselves make a lot of sense in the fixed-income space right now. This particular slice of the corporate-debt market, which is rated just below investment-grade, is becoming so attractive on a risk-reward basis that some portfolio managers are even using it as a surrogate or enhancement to equities.
With yields hovering around 8%, a lot of higher-quality junk bonds stack up nicely against the less frothy market.
But they also represent an ideal cushion for a rising-interest-rate environment by having the extra yield to offset the impact of falling bond prices that often coincide with rising rates.
“We've been a big fan of high yield, even though it had a big run last year,” said Kathy Roy, chief investment officer of fixed income at Calvert Investment Management Co. Inc. “Right now, it gives investors a pretty safe place to hide.”
As a broad category, single- and double-B-rated corporate bonds gained more than 45% last year. This compares with a gain of nearly 97% for the much riskier triple-C-rated junk bonds.
Investment-grade corporate bonds, meanwhile, gained nearly 20% in 2009.
Some of that extreme performance disparity between the lowest- and highest-quality junk bonds was reflective of a voracious appetite for yield without as much regard for risk.
But as the global credit system absorbs new shocks in the form of the debt crises in Dubai and Greece, a more tempered investor appetite should cool the performance of the riskiest debt.
This brings us back to the sweet spot of single- and double-B-rated corporate bonds.
“People forget that these are solid companies issuing this debt,” said Lorenzo Newsome, president and chief investment officer of Xavier Capital Management LLC.
Some of the household names with below-investment-grade debt include Macy's Inc. (M), Sprint Nextel Corp. (S), and Toll Brothers Inc. (TOL).
“An equity manager can't look you in the eye and say a stock is going to yield more than 8% over the next couple of years,” Mr. Newsome said. “But I'll take that return from a bond in a low-yield environment like this.”
This is precisely the approach adopted by Mark Travis, president and chief executive of Intrepid Capital Management Inc.
The Intrepid Capital Fund (ICMBX), which he manages, is a small- and mid-cap equity fund that currently has a 29% allocation to high-yield bonds.
“In our flexible structure, we can look across a company's capital structure to find inefficiencies,” Mr. Travis said.
For investors wary of the high-yield category, the declining rate of corporate-bond defaults should provide some comfort.
The analysts missed the mark at the end of 2008, when the 2009 consensus forecasts were for a 20% default rate on corporate bonds.
The actual default rate last year came in at just over 10%.
This year, with anticipated improvements to corporate earnings, the default rate forecast is down to 4%.
Although it is true that below-investment-grade debt reflects the challenges that a company faces, it is also important to remember that if the company goes bankrupt, a bond's ranking in the capital structure is placed ahead of the stock, even if its status is junk.
Among mutual funds, there are a few different ways to gain exposure to high-quality high-yield bonds, according to Morningstar Inc. analyst Eric Jacobson.
For a balanced approach, one option is to allocate to two or three different bond funds, focusing on different corporate bond categories.
In terms of going specifically after the higher-quality-junk category, Mr. Jacobson prefers “leaving it up to the individual manager,” he said.
With that in mind, Mr. Jacobson cited the Pimco High Yield Institutional Fund (PHIYX), offered by Pacific Investment Management Co. LLC, as an example of a fund that “leans toward higher-quality junk.”
And for a more aggressive approach, Mr. Jacobson said the Eaton Vance Income Fund of Boston (EVIBX), offered by Eaton Vance Corp., “has had some success at going back and forth” in and out of higher-yielding bonds.
“The Eaton Vance fund seems to be good at making tactical plays, and they're also good stewards of capital,” he said. “It's tough to find managers who are really good at it, because the closer you get to turning on a dime, the closer you get to market timing.”
Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].
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