4 obstacles to high-yield returns

Clients can still benefit from high-yield bonds.

But the task of choosing them should be delegated to professional managers, says Patrick O’Toole, vice president of global fixed income at CIBC Asset Management. He co-manages the Renaissance Canadian Bond Fund, an underlying fund in the Renaissance Optimal Income Portfolios.

Read:

• 4 benefits of high-yield assets
• How to create a yield cushion

High-yield bonds must be selected and allocated with care, he adds, since diversification is key when investing in riskier sectors such as high yield.

Read: Unwind an over-concentrated portfolio

Your clients must also watch out for the following four trends:

1. A rise in company defaults. “We’ve seen very low default rates over the last couple of years,” says O’Toole, but that can change.

For now, he adds, “Companies’ balance sheets [are] very healthy so we’re not concerned about seeing a wave of defaults. [In fact], the high-yield market…still [has] a certain amount of discipline on the issuer side…You’re not seeing [companies] ramp up M&A activity and taking on lots of leverage. [Instead], you’re seeing more rational behaviour,” such as companies calling for higher bond coupons and refinancing by issuing lower coupon bonds.

“That’s a benefit for…companies [and] current buyers of newer bonds,” says O’Toole, since companies are lowering their coupon payments improving their cash flows.

Read: Search for hidden investment gems

2. A rotation into low-risk assets. High-yield bond investors are increasingly moving towards so-called safer assets, such as government bonds. This was evident in January when emerging markets struggled, says O’Toole.

On the bright side, that trend “proved to be fairly temporary [and] high-yield bonds are still doing fine,” he adds. The upside of volatility is investors can consider “buy[ing] high-yield bonds at cheaper levels.”

Read: Handling bonds in a low-rate environment

3. Economic downturns. These weigh on returns, says O’Toole, but another downturn isn’t likely to occur any time soon. The economy’s sluggish but has a “better backdrop than we saw in 2013.”

4. Strengthening ETF flows. Flows out of bonds can reduce clients’ returns and liquidity. When the U.S. Federal Reserve first mentioned tapering in June 2013, flows out of riskier products such as high-yield bonds caused some temporary issues in the space, notes O’Toole.

Read:

• ETF inflows hit nine-month high
• Don’t bet against bonds

This year, high-yield bonds will offer solid fixed-income returns, predicts O’Toole. They may not be as high as in previous years, but clients’ portfolios will benefit more from high-yield offerings than from investment-grade and government bonds.

Their main advantage is they’re less susceptible to a rise in government bond yields. “They’re stock-like,” says O’Toole, “[so] you’re more worried about how…compan[ies] are performing [than about] how the central bank’s going to be managing short-term interest rates.”

Last year, the yields of most types of bonds rose, he adds, but high-yield bonds still did well since they’re more defensive. In particular, the extra yield they offer helps cushion portfolios by lowering overall volatility for fixed-income investors, says O’Toole.

Read:

Adapt to rising rates

Prepare bond investors for year ahead

Can you beat rising interest rates?