High-yield corporate bonds might be appealing in low-rate environments, but “there’s potential for default, and the credit risk is higher,” says Nicholas Leach, vice-president of global fixed income, high yield at CIBC Asset Management.

“Holding a few corporate bonds in an investment account is not the proper approach.”

Read: Corporate bonds mitigate U.S. growth risks

To mitigate interest rate risk, says Jeff Waldman, head of global fixed income at CIBC Asset Management, “The best approach […] is to buy both investment-grade and high-yield bonds.”

That’s because “corporate bonds have lower interest rate risk than government bonds, and high-yield bonds have lower interest rate risk within the corporate sector,” adds Waldman.

By buying different bond types, “you can achieve a balance of diversification of industries, companies, default and interest rate risk.”

Read: Why GICs beat bonds

Leach says there are still buying opportunities.

“Even in this low-yield environment, there is still potential for capital gains if we can find underrated and undervalued securities,” he says. “We can also find securities that may benefit from being called early,” which a lot of companies are doing because rates are low. “They have to pay the bondholders a premium in order for us to agree to a new transaction to refinance the current bonds.”

Read: Great rotation is great myth

But this environment also means there’s lower margin for error.

“We avoid issuers that cannot articulate a use of funds that is positive in the long-term for the credit quality of the company,” Leach says. In a low-yield environment, “issuers try to sell bonds with weak covenants, and inappropriate terms and conditions that aren’t in the best interests of protecting the collateral for the bond holder. We sacrifice yield when we need to in order to maintain a higher level of credit quality.”

As well, high yield bonds are sometimes overvalued in this type of market, says Patrick O’Toole, vice-president of global fixed income, active bonds at CIBC Asset Management.

“You could make the case that high-yield bonds are looking rich at the present time. We don’t see that same richness when you’re looking at investment-grade bonds.”

Read: Choose non-financial companies

O’Toole adds, “The actual spread on investment grade bonds today is still higher than average. When looking back the last 30 years, you could conclude investment grade bonds are cheap versus government bonds; so investors should be balanced between investment-grade and high-yield.”

Originally published on Advisor.ca

Add a comment

You must be logged in to comment.

Register on Advisor.ca