3 Reasons To Underweight High-Yield Debt

November 11, 2014

The justification for owning high yield at today’s levels stems more from its relative attractiveness versus other fixed-income sectors than from its own inherent value. Some would argue that today’s low-risk premiums merely reflect the low default rates currently in the high-yield space.

While this may be true, the corollary to that argument is that all the good news is currently priced into the junk bond market, and any subsequent bad news should be met with lower prices.

Annual_Default_Rates

Relative to other asset classes, however, high yield appears overbought and its return profile increasingly asymmetric, in our view. Under current conditions, we would expect—at best—low to midsingle-digit returns over the coming year. Downside risks could be significantly greater should we see default rates rise or interest rates and credit spreads widen to more historical norms.

‘Junkier’ Than Usual …

Our second cautionary flag in the high-yield space stems from the increasingly poor quality of bonds being issued. With the drop in interest rates to historic lows, companies have been eager to issue debt to secure low financing costs.

Annual_Issuance_Insurance

At the same time, investors have been all too eager to absorb this supply as the options for income-seeking investors have dwindled. But investors are now being paid less for taking more risk, with many traditional bondholder safeguards forgone thanks to this high demand.

 

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