LONDON: High-yield corporate bonds are unlikely to repeat this year’s rosy performance in 2011 as inflation threats and a stronger appetite among companies to releverage pose risks to what many see as a crowded market.
The typical underperformance of corporate debt to equities in an expansionary economic cycle, which many investors believe financial markets are in now, and the lingering euro zone debt crisis are also likely to take the shine off these bonds into the new year. Correlation data shows “junk” bonds – riskier paper rated below investment grade -are now trading like equities, benefiting from demand from investors seeking risky but high-yielding investments.
Contrary to initial expectations, junk debt extended its stellar performance of 2009 into this year as the Federal Reserve (Fed) embarked on a second round of quantitative easing and the European Central Bank has kept its liquidity operations in place and will do so until at least next March.
But the longer this low-rate environment drags on, the bigger the risk becomes for future inflation and an ensuing monetary policy response.
And unlike equities, high-yield bonds are particularly vulnerable to this looming interest rate threat, known as “duration” risk.
“High-yield debt has begun to behave like high dividend equities, capital guaranteed. There is an unforeseen level of vulnerability from an interest rate shock,” said Merrill Lynch Asset Management Chief Investment Officer Bill O’Neill.
JP Morgan estimates show retail high-yield funds have seen three consecutive weeks of outflow. In the past few weeks, $1.5 billion has been taken out versus year-to-date inflow of close to $10 billion, representing a 15 percent reversal.
Fund tracker data shows investors pulled $639 million out of high yield bonds in the week ended Dec 3, which was the biggest since early June. Barclays Capital expects US and euro zone high-yield bonds to give a total return of 5-6 percent and 6.5-8.5 percent respectively next year. That is less than half of this year’s total average return of around 14.5 percent.
This compares with return forecasts for world stocks of many analysts of up to 20 percent.
“We think there is a potential yield curve back up that will damage (corporate bonds) and we will have to try and put some hedging instruments in place against our interest rate exposure of our credit portfolio,” said Percival Stanion, head of asset allocation at Baring Asset Management.
Stanion said hedging ideas included shorting UK government bonds to offset any rise in gilt yields that would be a drag on corporate bond performance. “The same I think applies in the junk space. It clearly had such a huge move in such a short space of time that we are not going to get anything like that return going forward,” he said.
