The moribund stock market, "measured" rate increases and unpredictable economic growth have surely flummoxed many investors this year. But that could mean happier times for holders of high-yield bond funds.
Shaking off a rocky start, the average high-yield bond fund is up 5% this year. Now many fund managers are saying the slowly expanding economy has entered the perfect environment for high-yield bonds.
"From terrorism to oil to the election, it seems like there is no catalyst to get people to buy stocks," says Bruce Walbridge, co-portfolio manager for the
State Street Global High Yield Bond fund. "So now they are willing to take the additional risk to pick up some extra yield."
"High-yield is the place to be in a slow recovery," says Cynthia Cole, director of corporate bonds at the Armada Funds. "Companies will be strong enough to make their coupon payments. But they won't be doing so well that investors will switch back to stocks."
Whether they were spooked by the threat of rising interest rates or just looking to take money off the table -- high-yield funds posted an average gain of 24% in 2003 -- high-yield fund investors spent the first half of 2004 running for the hills. High-yield funds averaged $1.76 billion in outflows through May, including a $5 billion redemption blast that month, according to fund tracker AMG Data.
But with growth expectations cooling as the year has gone on, investors have grown hungrier for fund yields now averaging close to 8%. That's especially the case when the 10-year Treasury is yielding a paltry 4% or so.
Since the May blowout, net inflows have crept upward from $208 million in June to $787 million in August. AMG says September inflows are closing in on $400 million, making it likely the market will be seeing a fourth positive month in a row.
"There has been a sentiment shift in direction for high-yield funds as interest rates stabilized," says Bob Adler, president of AMG Data. "And the magnitude of the inflows is increasing."
Companies looking to take advantage of the market are issuing more high-yield bonds, according to fund managers. Armada's Cole says supply will grow as long as yields remain at basement levels. And from a seasonal standpoint, she says, the calendar will be busy through the holidays. That could add a bit of volatility to the high-yield market but won't seriously threaten demand in an area that's often overlooked anyway (though fund giant Fidelity last week launched a new high-yield offering, the
Fidelity Focused High Income fund).
So if neither a bump in supply nor a telegraphed series of
rate increases can derail the high-yield express, what will it take?
"The thing you have to worry about in high-yield is recession," says Greg Hopper, portfolio manager for the
Julius Baer High Yield Bond fund.
Recession could snuff out the high-yield market as it did back in 2001 and 2002, when the stunted economy made it difficult for companies to meet their big coupon payments. GDP growth slowed to less than 1% in 2001 and just under 2% in 2002. As a result, defaults rose to record levels in those years, hitting a high of 10.89% in January 2002, according to Moody's.
The current slow-growth environment -- GDP fell from 4.5% in the first quarter of 2004 to 2.8% in the second quarter -- has been far more kind to companies making good on their debt obligations. The default rate dropped to 2.26% in August 2004.
Martin Fridson, publisher of high-yield newsletter
, says, "As long as investors are comfortable that the economy is growing in the 3% range, then high-yield will be the asset class of choice." He places the cutoff for high-yield in terms of GDP growth at 2%. Lower than that, and he says default rates will once again escalate.
Finally, investors might have resumed shopping for high-yield picks, but fund managers are cautioning them not to expect many bargains. They say most of last year's 20%-plus gains came from bond prices increasing relative to Treasuries, something that will not recur in 2004 as so-called yield spreads have substantially tightened. Instead, investors will have to be satisfied with the coupon alone, which would mean an average annual return in the 7% to 8% range if the current state of affairs continues.
"The environment is good for high-yield, but there is not a lot of total return left," says Thomas Huggins, co-portfolio manager for the
Eaton Vance Income Fund of Boston. "The high-yield market might look good comparatively because there is nothing else out there. But on the whole, this is a 'coupon clipper' type of year."