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Treasure in the junk shop

There is an old adage in the bond market that goes: “When we or our clients own a bond, it is high yield. When someone else owns it, it is junk.”

But despite the fact that the mere mention of the “J word” is still enough to send many IFAs running for cover, high-yield corporate bonds have come a long way since the explosive early days of the US junk bond market of the late 1980s and early 1990s.

Of course, the major stockmarket correction at the start of the millennium has meant that it has not been the most comfortable of rides for investors, while the events of September 11 pushed back forecasts of when we might expect conditions to improve.

As Fatima Luis, manager of R&SA Investments&#39 maximum income bond fund, explains: “The attack on New York came at a time when default rates were already touching record levels of around 10 per cent. We went from watching the telecoms market overheat to witnessing the airline sector literally crash overnight, pushing up predicted defaults still higher.

“It wasn&#39t the actual levels of default that were causing the problems for everyday investors, though, it was the mistaken belief that this was somehow the prelude to mass destruction. There is no question that default rates are running very high, particularly in the telecoms sector which still drives the European high-yield market, but at the time it looked as if half the market saw the onset of double-digit defaults and ran for the hills.”

This meant that we saw some tremendous volatility in valuations towards the end of last year but, as Luis explains: “This only emphasises the importance of strong stock research and selection on the part of fund managers.”

The question for potential high-yield investors, as with all investment sectors, is whether or not things are likely to get worse before they get better. After all, the attraction of high-yield bonds is that, as well as promising a regular high income, they offer the potential of real capital gains as the credit ratings of issuing companies improves and the price of their bonds naturally improves. Timing the bottom of this market, like any other, is the key to making those much-sought-after extra gains.

Luis says: “The truth is, though, that the market has quietly bottomed out already. We may still have some way to go in terms of default rates but the worst is now long behind us. Experienced investors started to return to high yields back in November once the outperformance of investment-grade bonds (following the extended flight to quality) had run its course.

“What private investors with high-yield ambitions should keep in mind is that, while default rates tick slowly up to their forecast high, the peak in default rates has historically been a lagging indicator. This means that the best time to buy has always been while default rates are still rising toward their eventual peak.”

History confirms this. The last time bond prices were this depressed was during the Drexel disaster in the US bond market back in early 1990. The resulting rebound saw high-yield bonds make total returns of 44 per cent in 1991.

The other key point to remember about this asset class is that, despite a few recent hard-luck stories, high-yield bonds still have a lot to offer investors&#39 portfolios. As the graph below demonstrates, although high-yield bonds carry the highest risk, they have actually proven to be the single best performing asset class per unit of risk as measured by the Sharpe ratio.

There are few serious investors who can afford to ignore the benefits of the bond market these days. Whether it is a low-risk income that is required or a higher level of income and the potential for some serious capital appreciation, it is a company&#39s bond issues – not its equities – that will be of most help.

The problem is calculating what proportion of your clients&#39 portfolios should be occupied by bonds. One rule of thumb – which is as good a guide as any more technical advice – is to base the value of your bond holdings on your age. It is quite reasonable, for example, for a 50-year-old to have 50 per cent of their savings in bonds and for a 75-year-old to invest 75 per cent in bonds.

The tougher question is how much should the average investor hold in safer, investment-grade issues and how much should they hold in high-yield bonds. Unfortunately, there is no handy adage to apply to this question. It all comes down to the individual, their age, circumstances and, inevitably, their attitude to risk.

But there is one fact that should help those investors intending to correct the balance within their personal portfolios. Because investment-grade bonds and high-yield bonds have a very low correlation in terms of events which impact on their relative valuations, it is easy to demonstrate that mixing both types of bond within a portfolio actually helps to reduce the total level of risk faced by investors (see graph above).

This means that if you were to sell half your investment-grade bond holdings and replace them with high-yield bonds, you would actually be increasing your potential for capital appreciation and a higher level of total yield but with only a marginal increase in investment risk.

The only remaining question is when to make the move to high yield. Luis says: “If you are still here in a year&#39s time wondering whether to get your feet wet, then don&#39t worry – you will have missed the boat.”

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