Given the heady double-digit gains of the past four years, high yield investors might be excused for wondering whether the market is poised for a pullback. Matt Conti, manager of Fidelity® Focused High Income Fund (FHIFX), says that total returns might be more tempered at this point in the economic cycle and opportunities for prices to go up are limited. Still, he says high yield bonds offer a relatively attractive yield spread versus Treasury bonds, which could act as a cushion if rates rise.
In a recent interview with Viewpoints, Conti noted that high yield issues currently pay around 5%, with lower-than-average default rates in the safest BB-rated sector1 of the non-investment-grade market. With rates expected to remain low (due to Federal Reserve policy), Conti believes that high yield may continue to deliver positive returns, though the lofty capital appreciation from the depths of the recession has played out for now.
What is the big-picture view of the high yield market right now?
Conti: It has been a phenomenal period to be a high yield investor. The market has posted four years of what I would consider eye-popping total returns since the recovery from the 2008 crash started. Over the past four years, through December 31, 2012, high yield bonds have returned more than 20% on an annualized basis. The BB sector, which currently has the highest credit ratings in the high yield market, has also done very well, returning more than 17% during the same period.
That said, returns from here on may be more challenging as we move later into the economic cycle, because there is a limited upside for capital appreciation to help offset the potential for capital depreciation. Given today's valuations, I don't think investors should expect high yield bond prices to go up much from here.
So if you see limited opportunity for prices to go up, should investors still consider putting money or keeping money in high yield?
A: If investors are looking for capital gains, this may not be a great entry point. However, if an investor is looking for income or yield as part of his or her portfolio, high yield still looks attractive. Interest rates are very low throughout the fixed income universe, but the benchmark index for high yield bonds runs in the mid-5% range for yields and in the mid-4% range for higher-quality BB-rated bonds.2 So, while the risk profile is different, the yield is still attractive relative to investment-grade assets, and money has continued to flow into the high yield asset class.
That said, at this time, I think credit conditions look reasonable. High yield bonds always carry a risk of loss, but many companies restructured their debt at lower rates in recent years, and that decreases their financing burden. In addition, the economic recovery seems to be on track, and corporate balance sheets generally look healthier than they did a few years ago. Companies are beginning to take on more debt, but the levels are still reasonable at this point. Overall, we think a reasonable case can be made for those bond investors who can tolerate the risk of high yield to continue including an allocation for its income potential.
Bottom line: The big returns from recent years may not happen again, but the income paid by high yield bonds may be attractive in today's low-rate environment.
What is the general default rate for BB-rated bonds?
Conti: In early March 2013, the default rate was more than 3% for all high yield bonds in the United States, and near zero for BB-rated bonds—well below the historical average of 4.9%. If you remember, in the last recession, it was more than 13% for the high yield market. The rate is quite low because credit conditions have remained favorable and interest rates have remained low. Many issuers have refinanced debt further into the future, and the low rates reduce the interest obligations for companies. This allows them to deploy cash in other ways, such as reducing debt—which is obviously favorable for the balance sheet and for default risk. I don’t see much changing in the near term, so I expect the default rate to stay below average.
Why do you think investors are attracted to these issues?
Conti: The problem is, there's very little yield in most types of investment-grade fixed income today. So that forces investors to look at asset classes like high yield, where there still is some income. As of early March 2013, the spread between BB-rated high yield bonds and the 10-year Treasury is just under 250 basis points, so on average you're getting nearly 2.5 percentage points more in high yield bonds than in government securities. Of course, there is an increase in credit risk as well, but the yield pickup is a compelling argument for many investors.
What could happen if rates begin to move higher?
Conti: When interest rates move higher, bond prices tend to fall. In high yield bonds, though, the wide spread versus government issues may act as a cushion. Of course, as Treasury rates move up, the spread could narrow. So with average prices recently above par, at this point there is virtually no room for capital appreciation in high yield. But you would still be getting a relatively decent income payout.
In other mid-cycle periods similar to this one, the spread for the BB-rated market against 10-year Treasuries has been inside 200 basis points. As I said, in early March, we were at nearly 250 basis points, so arguably there is some cushion there. Treasury yields could go up, and high yield rates could stay pretty much flat.
Another way to hedge interest-rate risk is through floating-rate notes—essentially, bank loans that have floating interest rates. They are cousins of high yield bonds, but because loans are often senior to bonds on the issuer’s balance sheet, as well as secured by collateral, some investors consider these loans less risky. If rates go up, the terms of these loans require their coupons to reset higher. High yield floating-rate notes generally compose about 5%–10% of my fund.
Are there particular areas of the market you find attractive?
Conti: Though some names have run their course, I continue to make a number of what I would call cyclical bets in the market. One is the auto industry, which obviously got a lot of attention during the recession. It’s a good example of an industry turnaround, where fundamentals are starting to improve. I have specifically looked at situations where the balance sheet can improve enough so that the debt might get upgraded from BB to BBB—the lowest credit-rating tier for investment grade. The investment-grade market is five times larger than high yield, and so demand would go up tremendously for those bonds if ratings moved up.
Are there other cyclical themes you have seen playing out?
Conti: A second area I like is aircraft leasing, which is another cyclical play. During the recession, there was a very low replacement rate for aging aircraft. Now, however, airlines have been starting to upgrade. They've had a boost from financing—they can access relatively cheap money to upgrade—which benefits leasing companies. However, the trend is not global, because obviously Europe is facing hard times and we’ve had some airline bankruptcies there. But the leasing companies have the ability to shift planes to areas where there is demand—taking them out of Europe, say, and leasing them in Asia.
I also have been interested in housing—that sector has been experiencing a rebound. With existing sales and the working through of foreclosure inventory, I think there have been solid signs that a housing recovery will continue. Backlogs of some of the homebuilders have been going up every month, and the financing environment is obviously very positive. It’s benefiting not just the builders but also a lot of the companies that deal with the materials that go into homes—contractors, building material suppliers, and distributors. So there are a lot of ways to play this trend.
Recently we have seen a U.S. energy renaissance in natural gas and oil exploration and development. The high yield bond market has been a funding source for the energy sector, and some of that debt has provided investors with attractive opportunities, in my view. As we enter the late stage of the economic cycle, more stable companies in the utilities and cable TV sectors have become more attractive.
In general, I look to companies that use high yield debt in an intelligent way to grow their business. They raise debt to do acquisitions and expand, and then they generate the free cash flow to pay down the debt. But this takes the combination of a skilled management team working within a particular business—that is, it's much more company-specific than industry-specific.
Can an individual investor go out and buy these bonds?
Conti: High yield bonds are an over-the-counter market, with sales arranged by buyer and seller. For overall diversification, the easiest way to get that is through a fund. We have analysts looking at these issues all day long, measuring risk, evaluating management. That can be challenging for an individual investor.
For individuals who feel capable of managing the risks, research, and trading costs, Fidelity offers high yield corporate bonds on Fidelity.com along with historical trading data and third-party credit analysis to assist you in the research process.
- Learn more about the fund Matt Conti runs, Fidelity® Focused High Income Fund (FHIFX), and Fidelity's other high-income funds.
- Check out Fidelity's tools for individual high yield bonds.
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About the manager
Mr. Conti joined Fidelity in 1995 as an analyst and has since covered high yield bond investments in various industries, including telecommunications, cable/media, autos/transportation, and retailing. Mr. Conti received a bachelor of science degree in mechanical engineering from Carnegie Mellon University in 1988, a master of science degree in mechanical engineering from Rensselaer Polytechnic Institute in 1992, and a master of business administration from Columbia Business School in 1995.
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