Junk bonds remain risky for investors in search of yield

HIGH-yielding bonds have been very popular with investors recently. Uncertainty and the challenging investment environment have pushed investors into fixed-income. But because of increased demand, yields on good quality fixed-income investments have collapsed. Investors have had to look further afield to achieve returns.

The UK’s 10-year government debt yield now stands at around 2 per cent. In the middle of 2012 it was lower, knocking around a lowly 1.5 per cent. Given that UK consumer price index inflation is 2.7 per cent, in real terms investors lose money by parking their cash here. In effect, you’d be paying the government to hold your money.

THE ATTRACTION OF JUNK
Unsurprisingly, investors have piled into high-yield bonds, or junk bonds, as they hunt for inflation-beating income. A junk bond is rated BB or below, and carries a higher risk of default. On the other hand, high-quality bonds, like UK government debt, are rated triple-A as there is a lower risk of default (whether the UK will maintain its triple-A status is another matter).

Data from the Investment Management Association (IMA) shows that 2012 was a buoyant year for the IMA sterling high-yield sector. Retail investors poured a net of £514m (up to November), which is significantly up from £273m seen in the whole of 2011. Assuming that December continues the trend, 2012 will be a record year for net inflows since the IMA began classifying the sector in 2008.

It is understandable why investors have found the sector attractive. Morningstar data shows that the average fund within the IMA sterling high-yield sector currently yields over 6 per cent, and has returned 19 per cent over the last year.

But it is questionable whether this level of performance is sustainable. Rick Rieder of BlackRock argues that the sector is still attractive, as default rates have remained low, and current yields adequately compensate investors for the risk that they are taking. But he says that valuations are “not as attractive as in recent years, limiting the potential for returns from high-yield bonds in 2013”.

APPROACHING BUBBLE TERRITORY
This begs the question about whether junk bonds are in a bubble. Charles MacKinnon of Thurleigh Investment Managers believes that “the majority of the easy gains have already been made,” but thinks that they are currently correctly priced.

Going forward, however, the risks are clear. If investors continue to buy junk bond funds at the rate they did in 2012, high-yield could be entering bubble territory. As headwinds that have shaken the global economy begin to dissipate, junk bonds will become less attractive compared to equities, and will fall in value. And it appears as though this time is approaching quickly.

MacKinnon says that we are at the beginning of the end of the global rally in bonds, yet there is still a place for them within a balanced portfolio. But he cautions that high-yield bonds should only form a part of your portfolio – not a significant chunk. He suggests that they do not exceed 10 per cent of your bond allocation. MacKinnon also says that you should look for solid funds that are “not doing stupid things”.

There are six funds that have produced a positive return every year from 2008 to date (excluding 2008 itself, when none of the funds in the sector performed positively). Of these, the Kames High Yield Bond A Inc and Pimco GIS Global High Yield Bond I Hedged Inc have been the best performers, respectively returning an average of 12.8 per cent and 10.5 per cent.

Nevertheless, the warning signs are there. This sector should be approached with the utmost caution.