Analysis: Bond managers fret junk bond rally is losing steam

NEW YORK Wed Feb 27, 2013 12:14pm EST

Traders work on the floor of the New York Stock Exchange, February 13, 2013. REUTERS/Brendan McDermid

Traders work on the floor of the New York Stock Exchange, February 13, 2013.

Credit: Reuters/Brendan McDermid

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NEW YORK (Reuters) - There may be no such thing as a sure bet on Wall Street, but junk bonds have come pretty close over the past four years. Now the high-yield market feels frothy enough to a number of the biggest bond market players that they are shying away from junk.

Bonds of the riskiest U.S. companies have delivered a total return of 143 percent since bottoming in December 2008. A widely followed measure of the sector, the Bank of America/Merrill Lynch High Yield Master II Index, hit an all-time high last month and sits just a smidgen below that record.

"This market started off the year with hyper activity," said Dan Fuss, vice chairman and portfolio manager at Loomis Sayles, which oversees $182 billion in assets.

An aggressive effort by central banks like the U.S. Federal Reserve to suppress interest rates on safer assets like government debt has triggered a massive yield hunt among bond managers. That has translated into big demand for high-yield bonds, also called junk bonds because they sport below-investment-grade ratings by Standard & Poor's and Moody's.

As a result, effective yields for junk bonds dropped to a record low of 5.84 percent in January, according to the Bank of America index.

Now, even with effective yields creeping back up to just over 6 percent this month, the market "feels like it's been priced to perfection," said Bonnie Baha, head of Global Developed Credit at DoubleLine, which oversees $53 billion.

Baha and Fuss have both cut back their junk exposure.

The flagship $22.7 billion Loomis Sayles Bond Fund has slashed high-yield bonds to just 24 percent of assets, the lowest ever, from about 35 percent a year ago. Fuss also has reined in his duration risk, lowering the fund's average maturity to nine years from a peak of 19 years.

Fuss and others worry the Fed's easy money policy - short-term interest rates held at effectively zero and a bond-buying program known as quantitative easing - will soon foster inflation, a bond manager's biggest fear.

That would drive up interest rates, so bond prices, which move in the opposite direction to rates, would fall.

Financial markets were spooked last week when minutes from the Fed's January meeting showed some policymakers divided over how long quantitative easing should last. Against this backdrop, Fuss and Baha are bracing for bond yields to rise.

"The 'don't fight the Fed' mentality, which has been driving corporate bonds prices higher, will have to reconcile at some point with the macroeconomic reality that there's more risk in the world than the market is choosing to acknowledge," Baha said. "We're coming into a period where credit selection matters a lot. Buying credit blindly - a la the ETF space - is a dangerous game."

The 13 U.S. high-yield bond exchange traded funds (ETFs) tracked by Lipper pulled in nearly $8 billion of new investor money in 2012, and total assets shot up more than 50 percent to nearly $32 billion, including market performance. Investors so far this year have yanked more than $1 billion from the sector.

The iShares iBoxx $High Yield Corporate Bond Fund, which accounts for nearly half the assets in the group, has seen four straight weeks of outflows, totaling $905 million.

REALITY CHECK

Bond managers are also getting worried that junk bond valuations are getting stretched relative to stocks, their chief competitor in the realm of risk assets.

Junk bonds' average yield to maturity recently fell below the earnings yield on the S&P 500, the inverse of the price-to-earnings ratio and used by fund managers to compare valuations with bonds.

That is an anomaly and was its widest in late 2012 when junk yields were 0.57 of a percentage point lower than the S&P earnings yield. Last week, that had narrowed to 0.37 of a percentage point.

By contrast, junk bond yields since 1986 have averaged 4.94 percentage points above the earnings yield. While stocks overall are a riskier asset class than junk bonds, the S&P 500 earnings yield historically has been lower because it is a yardstick for the risk of owning the highest-quality stocks compared with the expected return on the lowest-quality bonds.

Junk bonds have lagged stocks so far in 2013 after both returned roughly 16 percent last year. The S&P 500's year-to-date total return through Monday was 4.7 percent, but just 1.7 percent for junk bonds.

Their growing skittishness notwithstanding, few bond managers expect an outright sell-off in high-yield bonds, given the Fed's determination to keep driving investors to take on more risk and expectations for continued low default rates.

The ability of so many companies to refinance their debt at substantially lower interest rates over the past four years has strengthened the cash flow profiles and balance sheets of many junk issuers.

Yet dividend-paying stocks have become attractive alternatives to junk and investment-grade corporate bonds.

Kathleen Gaffney, co-director of investment grade fixed income at Eaton Vance, said she believes equities will perform solidly this year. Her Eaton Vance Bond Fund can hold up to 20 percent of assets in equity and is already halfway to that threshold.

"I'm watching for opportunities ... to add," she said.

Gaffney also calls syndicated loans an "easy trade-off" for pricey junk bonds. In addition to higher standing in the capital structure, an important edge in case of bankruptcy, they are better protected from rising interest rates because they are generally pegged to floating-rate benchmarks. By comparison, the value of fixed-rate securities is hurt by rising rates.

"Loans are the best possible place in capital markets globally right now, from a risk/return standpoint," said Oleg Melentyev, credit strategist at Bank of America Merrill Lynch.

Loan funds have attracted $8.2 billion in new money in the past 12 weeks, Melentyev said. That amounts to 16.7 percent of the group's total assets of roughly $80 billion.

The current yield to maturity on the Standard & Poor's/LSTA Leveraged Loan 100 Index, which tracks the leveraged loan market, was 5.13 percent. The total return on the index so far this year is 1.31 percent.

"The main thing to be concerned about now would be the interest rate risk," said Martin Fridson, chief executive of research firm FridsonVision LLC.

"It seems to me unlikely that interest rates are going to go lower. In that sense, it's a good time to be in loans."

(Reporting By Jennifer Ablan and Sam Forgione; Editing by Dan Burns and Nick Zieminski)

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