* High-yield bond funds seen slowing after stellar 2012
* Yield-hungry investors drove up demand
* Default rates are very low, but new issuers flood in
By Andrea Hopkins
TORONTO, March 4 After three years of fantastic
returns and a particularly stellar 2012, Canadian asset managers
predict a return to earth for high-yield bond investments as
surging demand and recovering stock markets take the shine off
While no one is saying the party is over - solid
single-digit returns will still far outstrip returns on
government or investment-grade debt - wealth managers say it is
time to start reducing the expectations of junk bond buyers.
"We had a great year last year, our life was wonderful and
the sun was shining every day," said Lorne Steinberg, president
of Montreal-based Lorne Steinberg Wealth Management, whose
Steinberg High Yield Fund notched a 13.7 percent return in 2012.
"This year we are cautioning clients that the lovely
double-digit return in 2012 is not going to be repeated in 2013
... we're looking to be in that mid-single digit, that 6 percent
area this year."
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 a record high in January
and sits just a smidgen below that record.
With yields on safer assets such as government debt near
historic lows, bond managers and investors have flocked to
high-yield bonds, also called junk bonds because they sport
below-investment-grade ratings by Standard & Poor's and Moody's.
"Since the financial crisis, as more investors have flooded
into fixed income, this spread differential has come in and we
have seen yields on both investment-grade and high-yield bonds
decrease," said Ilias Lagopoulos, fixed income portfolio
strategist at RBC Wealth Management.
RBC's Global High Yield Bond Fund notched one-year return of
11.7 percent and a three-year return of 10.2 percent, but the
latest one-month return was negative 0.2 percent.
Lagopoulos doesn't think the good times are totally
finished, in part because interest rates aren't expected to rise
any time soon, ensuring a solid spread differential remains
between investment grade and high-yield debt. In addition,
default rates - the principal risk of junk bonds - have fallen
to near historic lows because cheap money has strengthened
corporate balance sheets.
Junk bond issuers are typically technology or, in Canada,
resource companies that haven't made any money yet, or, more
typically in the United States, investment-grade companies that
have fallen on tough times.
While the default risk may have eased for junk bond issuers,
Steinberg said the new risk is that the demand for high-yield
debt is drawing new creditors into the market who may offer less
protection to investors.
"What happens it is there is so much demand it becomes
indiscriminate demand, and issuers get away with looser
covenants - the protections don't have to be as great," he said.
Typically, a junk bond issuer has to agree to certain
conditions in a covenant, such as not selling any assets before
paying off bondholders. But each issue has its own covenant and
with high demand, such protections are getting looser, Steinberg
"For us, we spend our time on research, we simply avoid
those issues, but a lot of those issues get done because there
is just so much demand. So buyer beware."
There are two major ways for Canadian investors to get in on
the high-yield game: actively managed funds composed of a few
dozen bonds hand-picked by the fund manager, or exchange-traded
or index funds, which sidestep the expense of active management
by choosing a big, diversified pool of 200 or more bonds.
The majority of Canadian high-yield bond funds are comprised
of U.S. and Canadian debt issues, with the U.S. market greatly
overshadowing Canada's small junk bond market.
"Your main risk is individual security risk, the default
risk," said Rob Bechard, head of ETF portfolio management at BMO
Asset Management in Toronto.
"So either you're going to pick a good manager that can pick
good companies that aren't likely to default, or if you are
picking an index product, look for one that doesn't have a lot
of concentrated risk, an ETF that has a lot of names in it, over
200," he said.
Bechard said BMO's High Yield U.S. Corporate Bond ETF,
comprised of some 250 individual bonds, notched a return of 14.6
percent in 2012. But now he believes a "wait and see" approach
may be the way to go as investors watch for the U.S. economy to
pick up or tank again as the budget crisis unfolds.
"Any investor who is looking to add (high-yield bond
exposure) to their portfolio has to be aware that it has had a
pretty good run," Bechard said.
RBC's Lagopoulos said a good strategy for yield-hungry bond
managers is to look for short duration credit, which will allow
them to be nimble and jump to better issues if rates rise or
jump to equities - most bond funds allow for some equity
exposure - as needed.
Steinberg said these days he'd rather have a 1.5-year bond
yielding 6 percent than a 10-year bond yielding 8 percent - just
to avoid the risk of rising interest rates because a bond that
is close to maturity won't react as much to rising rates.
"We have never been concerned with being the
highest-yielding high-yield fund in Canada. We've always been
concerned with having the safest high-yield fund in Canada that
still delivers a good return for our clients," Steinberg said.
"Because if you are going to shoot for the top returns, you
are going to at times take the excessive risk."