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Tight fit

There are still opportunities to be found in US high yield despite spreads being close to historical lows

After a decline in the second quarter of 2006, the US high-yield market resumed its trend of positive performance, returning 3.8 per cent in dollar terms in the third quarter but there are some concerns being expressed about this market.

The first burning question from bond investors is: “If there is a market downturn in the US, what effect will it have on US high-yield bonds?”

A sharp economic downturn may well have a negative effect on the price of high-yield bonds but it is important to remember that the total returns of high-yield bonds include a very important component – income.

We know that past perf-ormance is not necessarily a guide to future perform-ance but history does show that while the price movement of high-yield bonds can be volatile at times, the asset class has in the past provided a relatively steady income flow. Such an income can be a buffer in times of volatility as well as adding value to a diversified portfolio.

It is also important to remember that while high yield can be volatile, historically, stocks remain even more so. The divergence in performance among asset classes tends to diminish the overall volatility of a portfolio while also helping to bolster performance over the long term. Therefore, high-yield bonds in an investor’s portfolio can complement investment-grade bonds as well as stocks.

The second question many investors are asking at the moment is: “Is there value in US high yield, given the fact that spreads are at or close to historical lows?”

The tight spread between high-yield and government bonds – which is indeed at historically tight levels – is a measure of just how expensive high-yield bonds have become relative to the historical average, as well as an indicator of the increased risk tolerance apparent from investors. However, this does not imply that the high-yield market is devoid of opportunities.

The tight spread has been driven mainly by the higher-quality category of bonds, that is, BB bonds. These bonds have a spread of just over 2 per cent. At the other end of the scale, CCC bonds have a spread of more than 6 per cent.

This highlights the fact that there are still opportunities to be uncovered but that, to add yield to a portfolio, investors need to move down the credit curve to find them.

It is also important to remember that the spread is an indicator of the level of risk. In line with the tight spread, the default rate of US high yield has been on a declining trend over the last few years as a result of the gradual improvement in credit quality. Having peaked at more than 11 per cent in January 2002, Moody’s recorded a decline in the default rate from more than 8 per cent at the end of 2002 to just over 2 per cent at September 30, 2006. Rising interest rates and moderate economic growth are expected to reverse this trend and lift defaults in the high-yield sector to 3 per cent by May 2007. Nevertheless, this is still well below the long term average of 5 per cent.

Given the default outlook, I believe the spreads, although tight, are still at a reasonable level as balance sheets remain strong and bank market liquidity is very high. In such an environment, fundamental credit research plays an important role in the search for yield while avoiding bonds trading above fair value.

Harley Lank manages the Fidelity US high-yield bond fund

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