Don’t junk high-yield bonds, portfolio manager suggests

(February 12, 2004) With last year’s scramble for income products, investors found themselves driving yields lower by bidding up the price of their preferred investments. Given this drop in yields, some may question whether there is any room left to profit in the debt market.

“Given the relatively low interest rate environment and low government yield environment, I think investors should continue to look at high-yield debt,” says Scott Colbourne, vice-president and fixed income portfolio manager at AGF Management. “There remains interest in this sector despite the tremendous run we had in 2003.”

Colbourne, portfolio manager for AGF Canadian Total Return Bond Fund, AGF Global Total Return Bond Fund and AGF Global Government Bond Fund, predicts a stable environment of low interest rates for the foreseeable future, making high-yield debt — what used to be called junk bonds in the 1980s — more attractive.

“I think central bank policy will remain relatively accommodative in 2004,” says Colbourne. “Indeed, I think interest rates will remain lower than what the market expects for a longer period of time.”

He points to global inflation of about 1.5%, with no sign of inflationary pressures in the more influential economies, including the U.S. and the rest of the G-7.

“I don’t think there is likely to be policy mistakes by central banks or policy administrators, with central banks — by and large globally — targeting around 2%,” he says. “The experience we had between 1980 and 2000 is not likely to be realized again, where we had substantially higher inflation.”

There is some debate over the timing of a U.S. Federal Reserve rate hike. The last Fed meeting left investors scratching their heads as chair Alan Greenspan subtly reminded the world that interest rates would eventually rise.

“I think the Fed is trying to introduce the first of many subtle shifts that will gradually introduce the market to a tighter cycle of monetary policy,” says Colbourne. “The likely case is that the Fed will be on hold for 2004. They’ll gradually introduce the possibility that the central bank will tighten rates in the future.”

Even when the Fed does raise rates, Colbourne says the high-yield end of the debt market could still be a good bet.

“Over the longer period of time, below-investment-grade debt is relatively insensitive to interest rate changes,” he says, pointing out the further down the rating scale, the lower the correlation there is between a bond’s return and U.S. Treasury yields. Debt rated at “CCC” actually has a negative correlation.

In general high-yield debt has a shorter duration than government and investment-grade corporate debt. In the event of abrupt hikes in interest rates, high yield holders benefit from the short duration.

Another trend in favour of high-yield debt is the dropping default rate, which hit a recent peak in 2002 of 16.4%, but has now fallen to about 5%. Colbourne says both Moody’s and S&P predict the rate will continue to fall, indicating a possible drop in the risk involved in this market.

There is also a reduction in alternatives to high-yield bonds, as corporations have taken advantage of low interest rates to deleverage. Investment-grade coupons have dropped as companies extend their debts with low interest bonds and use the cash to repair balance sheets, buy back stock and pay down long-term debt

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com