Yahoo Finanzen Investment Risks to Watch For in the High-Yield Bond Market
Over the last several years, investors have been forced by the Federal Reserve's policy to take on more risk to obtain yield on their investments.
As yields on CDs declined from the 5 to 6 percent range in 2008 to a little more than zero, investors have purchased lower quality and riskier investments in an effort to maintain income. Also, the credit markets have been stable since 2008, which has led to a state of complacency. Investors need to pay attention to what is happening with credit markets today, especially in the high-yield bond space.
The decline in commodity prices is pushing some high-yield bonds toward default. The pressure on the energy and metals and mining sectors does not appear that it will be relieved in the near term. Energy and metals and mining issues make up a sizable percentage of high-yield bonds.
Accordingly, high-yield funds had a negative return for 2015, but things could get much worse. Investors see the yields coming from these funds as attractive, being in the range of 7 to 8 percent [using the iShares iBoxx High Yield exchange-traded fund (HYG) as a gauge].
The yield looks attractive, but what isn't apparent is that this market has become bifurcated. Yields on energy and commodity companies have expanded to the 12 percent range; the remainder of the market is in the 5.5 percent range. The 12 percent yield indicates a high expectation of commodity and energy companies defaulting. Standard and Poor's downgraded more than $1 trillion of bonds last year and the pace appears to be picking up.
On the surface, investors would naturally be attracted to a yield of 8 percent; however, they could be in for a rude awakening if financial stress in the energy area gets worse -- many of those companies could default, leaving investors with a large loss.
As of June 30, more than 80 percent of these companies' cash flow was going to service their outstanding debt -- this leaves little cash to fund operations. During this time, oil was still trading well above $50 per barrel. The situation has only gotten worse, with oil now trading in the $30s.
To add to the challenges, many high-yield bonds are not liquid. Individual investors likely own high-yield bonds through an ETF or an open-ended mutual fund. The general belief is that if they choose to sell they can easily do so, which is correct.
However, what is not usually obvious is what can happen to the price of a fund in an environment where people become fearful. If concern about the credit cycle gets worse and investors start selling their funds in large volume, the prices of the bonds underlying the funds can drop significantly, even without defaults. As fund investors sell, the fund's manager is forced to raise cash to pay out the redemption, and the manager has to sell part of the fund's holdings.
The corporate bond market is made up of thousands of different issues, many of which do not trade on a regular basis. When the fund manager is forced to sell, he/she needs to find a buyer. In a time of high-selling pressure, buyers tend to offer low-ball bids, or no bids at all.
Remember, the fund's manager has to sell, practically at any price, to meet the redemption request. The liquidity issue may be a larger risk to high-yield bonds than the default issue.
One thing is very clear: Energy and mining companies are facing ongoing and increasing headwinds. There is good reason the yields on energy and mining bonds has shot up so much, given the trouble they face. If investors own high-yield funds, they need to understand the exposure their funds have to these sectors -- and to the risk of defaulting bonds or large redemptions by other holders.
I do not think now is a time to be taking undo risk in the high-yield market. Some funds offer a different approach to high-yield exposure, however. Consider:
Market Vectors Fallen Angel High Yield Bond ETF (ANGL): Its holdings are junk bonds that were originally issued with an investment grade rating. Consequently, the credit composition of the fund is better than other funds. The SEC yield is 5.9 percent. While giving up some current income, we believe the overall superior credit profile of the fund will serve investors well. It likely will not avoid the volatility inherent in high-yield funds during a time of fear, but the credit quality of the fund should minimize the negative impacts of large defaults.
Metropolitan West High Yield Bond (MWHYX): The team that manages the fund has been in place since 2002. Their process focuses on individual credit analysis and attractive valuations.
Disclosure: Neither Phillips, his firm or the firm's clients own a position in the aforementioned funds.
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