High yield bond funds
Varying mandates explains returns
last article of 2002, I opined that the bond components of portfolios should
overweight corporate and high yield bonds. My call turned out to be a good one
as falling interest rates and a roaring stock market have propped up the whole
bond market, but particularly high yield issues. In my opinion, however, the
easy money has already been made, and now investors would do well to pay
particular attention to credit quality.
Since my recommendation to overweight high yield bonds in
December, corporate and high yield bonds have handily outperformed government
bonds. I estimate that government bonds in the Scotia Capital Universe Bond
Index have returned about 7.5 percent for the first seven months of this year,
but underperformed corporate bonds by more than two full percentage points
during the same period.
(Note: Corporate Bond is the term used to describe
investment grade debt issued by a corporation. High Yield is corporate debt that
is rated below investment grade or BBB.)
Thatís a substantial level of outperformance for a
moderate amount of extra risk. Among the lower quality, high yield debt issues,
performance was even more outstanding as the corporate and high yield bond
market has mirrored recent stock market activity.
Generally, stock markets around the world have done quite
well. In particular, itís the more aggressive stocks Ė in the information
technology sector in particular Ė that have really put up big numbers this year.
Whether you look at a U.S. comparison (NASDAQ vs. the S&P 500) or a domestic one
(S&P/TSX Canadian Information Technology vs. S&P/TSX Composite), youíll find
that tech stocks have outperformed the broader markets by about 20 percentage
points so far this year.
Interestingly, bonds issued by tech and telecom companies
are those that sported huge spreads above government bonds last fall Ė and that
have posted enormous gains ever since.
A look at high yield bond funds available in Canada shows
wide ranging performance numbers Ė from the StrategicNova Canadian High Yield
Bondís 18.9 percent gain to the 0.5 percent loss of CIís Signature Corporate
Bond fund. Why such disparity? Differences in strategy implementation explain
most of this. Letís look at two funds to illustrate this point.
StrategicNova Canadian High Yield Bondís top five holdings
currently account for about ľ of its assets Ė and all are telecommunications
issues. Trimark Advantage Bond (now only open to existing unitholders) not only
takes a more diversified approach (top five holdings make up less than 12
percent of the fund) but the bonds it buys donít have the same level of credit
risk or sector concentration. In short, Trimark takes fewer, smaller bets as
compared to the StrategicNova fund.
For the past several months, the market has rewarded those
taking higher risks, which explains the relatively greater success of
StrategicNova. However, that wonít always be the case.
With credit spreads having narrowed significantly since
last fall, the easy money has already been pocketed in the high yield market.
While funds with higher quality bonds trailed the pack in this hot market,
expect them to do relatively better going forward. High yield bonds are still a
good place to hold some fixed income in this low rate environment but dipping
down into distressed debt may no longer hold the return potential it did several
Buying low quality debt was attractive because prices were
so low it made the risk worthwhile. However, prices have risen dramatically so
better values are not likely to be as common among lower quality high yield
bonds. Rather, holding a fund that sticks to higher quality issues Ė like
Trimark, GGOF, and PH&N Ė may be a better bet going forward (and a better
diversifier versus stocks) given current valuations.
Dan Hallett, CFA, CFP is the President of Dan Hallett and Associates Inc., an independent investment research firm based in Windsor, Ontario. Dan can be reached at email@example.com.