In today’s market environment, investors are obsessed with yield.
In past columns I have noted investors’ increased interest in securities such as income trusts and closed-end funds for yield pick-up.
High-yield debt is often regarded as fixed income that offers the highest risk-reward tradeoff.
To achieve high yields, these debt instruments may have lower ratings, such as less than BBB investment grade as determined by rating services like the Dominion Bond Rating Service.
Most issuers of high-yield bonds represent a cross-section of some of the biggest names in Canadian business, such as Air Canada, Shaw Communications, Stelco and Hudson’s Bay Co.
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They all carry sizable debt on their books, which is exactly why their notes have been punished with such a low rating.
But oddly, while most investors seem to have no doubts about buying or selling equities, few are willing to accept the risk on the debt.
The bottom line is that if you are happy buying the equity of a company, you should be perfectly happy buying the fixed income from a risk-reward perspective.
Having high-yield debt in your investment portfolio offers three distinct advantages.
- A lack of correlation with other asset classes enhances portfolio stability.
Because corporate bonds are exposed to the financial position of the underlying company and the broader interest rate environment, they can be viewed as a hybrid of government fixed income and equities.
By not falling into either category, exposure to the sector can substantially lower overall portfolio volatility. The lack of correlation with government bonds is quite relevant when interest rates are rising. Rising interest rates are a sign of stronger economic activity and thus greater profitability for corporations.
This higher profitability translates into lower risk of default or missed coupon payments for holders of corporate bonds and higher prices for corporate bond issues.
- The yield available in the corporate bond market is considerably higher than government bonds of similar maturity.
For example, the Canadian high yield index is 600 basis points, or six percent, higher than the 10-year Government of Canada bond yield.
In part, this reflects the higher risk inherent in corporate bonds.
This yield spread is at the high end of the historic range and represents an opportunity for investors.
In the United States, the yield spread between government and corporate debt is similarly high in historic terms.
Although spreads have narrowed somewhat from the all-time high reached in the fall of 2002, the relative yield on corporate bonds remains noticeably higher than the average.
- The corporate bond asset class is a clear beneficiary of ongoing, widespread improvement in corporate balance sheets.
After the excesses of the late 1990s, North American corporations are now aggressively paying down debt while focusing on being more efficient.
Interest coverage ratios, which measure companies’ financial abilities to meet the interest requirement on debt, have begun to improve after a long decline that began in the fourth quarter of 1998.
Because corporate financial health is a key determinant of the market value of high-yield bond issues, stronger balance sheets have begun to translate into stronger returns in the sector and should continue to do so.
At this stage in the economic cycle, high-yield debt is poised to potentially outperform equity markets and other investment grade fixed-income products in the next few years.
Because of the comprehensive balance sheet analysis required before investment in particular high-yield issues, you may want to consider high-yield bond funds for exposure to the asset class.
By investing in a high-yield bond mutual fund, you receive the diversification that offsets the risk associated with individual company or sector-related events.
Ian Morrison is an investment adviser with Wood Gundy Private Client Investments in Calgary and is licensed to sell insurance products. His views do not necessarily reflect those of CIBC World Markets Inc. or The Western Producer. Morrison can be reached at 800-332-1407 or by e-mail at ian.morrison@cibc.ca.
