Are junk bonds the new alternative to stocks?
With yields now hovering at more than 6.5 percentage points over comparable Treasury bonds, it would be foolish to ignore what the high-yield market is offering, according to Jim Shanahan, one of the lead managers of the $11.6 billion JPMorgan High Yield Debt Fund Ticker:(OHYAX).
“Historically, people looked at high yield as an alternative to fixed income, but now they're starting to look at high yield as an alternative to equities,” he said. “When rates are very low, people think differently about where they go for returns.”
The high-yield-debt market is uniquely suited for the current market cycle because “you need less to go right to do well in high-yield bonds than you do in stocks,” Mr. Shanahan said.
The yield spreads of junk bonds over intermediate-term Treasury bonds tends to expand during periods of economic stress and compress during stronger parts of the market cycle.
Before the start of the financial crisis in the spring of 2007, for example, the yield on high-yield bonds was only about 2.5 percentage points over Treasurys. By late 2008, the spread briefly reached 20 percentage points.
What makes the high-yield bond market so attractive now, according to Mr. Shanahan, is that a lot of companies have used the past few years to clean up their balance sheets and get a better handle on their debt.
“When we're looking at high yield, we tend to think first about credit quality, and today it is rather good by historical standards,” he said. “Three years into an economic expansion, there has been enough time for companies to get their balance sheets in pretty good order.”
In terms of high-yield bonds' acting as an alternative to equities, Mr. Shanahan pointed out that the bonds are going to be much less volatile. “You really just need the company to pay its bills and you will do OK in the high-yield market,” he said.
Mr. Shanahan, who has been involved in managing the fund since it was launched in 1998, said he looks for companies at which the level of debt is relative to cash flow over a complete business cycle.
“There are no industry sectors that we avoid completely,” he said. “But we will tend to be a little more tactical in our thinking of the more cyclical spaces like steel manufacturing and auto parts.”
So far this year, the fund is up 7.1%, which compares with a gain of 2.9% for the
Barclays U.S. Aggregate Bond Index, and 7.7% for the S&P 500.
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