Investors who are wary of stocks but yearn for handsome returns may want to take a look at high-yield debt.
These bonds, which typically pay 7 to 10 per cent a year in interest, re-emerged in Canada in 2010. At the time, investors were desperate for any yield they could get above rock-bottom rates on government and corporate bonds.
Because they were so keen on returns, investors were willing to overlook the fundamental risk of any high-yield product: a much greater chance of default than with investment-grade corporate bonds. Companies that issue high-yield paper, like Quebecor and Air Canada, pay higher interest rates because the market demands compensation for the higher risk of losing money.
Still, demand for these deals has quickly escalated after a decade of inactivity, and 13 new Canadian offerings worth over $3-billion ultimately hit the market in 2010. Buyers still aren't satiated, and banks have invested heavily in staff who can issue, research and trade high-yield debt.
To date, retail investors have largely been missing from this market - in many cases because they don't know it exists.
But that looks likely to change. While the initial attraction of high-yield bonds was its substantial return, now "people want the protection of income, but they don't want to be exposed to rising interest rates," said Barry Allan, who runs Marret Asset Management in Toronto and manages a number of high-yield funds.
Typically, higher interest rates push down bond prices. But high-yield debt stays attractive because it is the least price-sensitive to interest rates, Mr. Allan said.
In theory, he said, 100 per cent of the volatility in the price of a government bond stems from interest rate movements. (Though, sovereign risk is now toying with that assumption.) Investment-grade bonds fluctuate in a similar fashion, with 80 per cent of price movements related to interest rates.
In contrast, only 20 per cent of movements in the prices of high-yield debt are tied to interest rates. Mr. Allan predicted that fact will be extremely important in 2011 because he expects 10-year corporate bond yields to jump anywhere from one to 1.5 percentage points higher.
Just like equities, high-yield bond prices fare better when the economy gathers steam, Mr. Allan said. As issuers generate better cash flows, their chance of default drops, so high-yield debt becomes less risky in a recovering economy.
Conversely, the biggest risk to high-yield investors would be if the economy slows and corporate defaults rise.
Filling Income Trusts' Shoes
But high-yield debt is more than just a bet on economic recovery. The sector is hot in Canada because income trusts have all but disappeared, said Greg Woynarski, co-head of fixed income at Scotia Capital, which now has five people dedicated to high-yield products. "Debt is becoming the new equity."
Back when trusts yielded 5 to 8 per cent in annual distributions, they effectively served the same function for income-seeking investors that high-yield debt does today.
The big difference is that income trusts were mostly large, stable companies with steady cash flows, while high-yield issuers are much riskier businesses. On the other hand, high-yield debt ranks higher in the event of a default, meaning the bonds would be paid back before trust units.
Investors who are comfortable with the risks associated with high-yield debt can invest in mutual funds that specialize in the debt. Examples include AGF's Canadian High Yield Bond Fund and BMO's U .S. High Yield Bond Fund. There are also options like Marret Asset Management's High Yield Strategies Fund, which is run by Mr. Allan and is a structured product that pays monthly distributions. However, its fees are higher than mutual funds.
It is much easier to find a high-yield mutual fund that invests in U.S. companies than it is to find a Canadian fund. That's because the $1.25-trillion high-yield market south of the border dwarfs Canada's $5.5-billion market.
Scotia believes many more Canadian dollar deals are coming. For Canadian companies, one advantage of issuing debt is that it removes the swap charges that issuers typically pay to convert their U.S. dollar debt back into Canadian dollars, Mr. Woynarski said. Legal expenses are also lower north of the border.
Even if new Canadian deals dry up, Mr. Allan said there will still be lots of opportunities to play in this market.
"We certainly welcome, encourage and do everything we can to develop Canadian issuers in Canada, but if we don't get [them] there are lots of things to buy in the U.S.," he said.
A YIELD MENU
Comfortable with the risks involved with high-yield debt? Here are a few ways to invest.
A slew of funds focus on this area, particularly the huge U.S. high-yield debt market. Investors more comfortable with Canadian names can look at products such as AGF's Canadian High Yield Bond Fund.
Barry Allan, who runs Dynamic's high-yield fund, also runs Marret Asset Management, which offers a high-yield structured product. This fund currently pays monthly distributions that amount to 8 per cent annually. The downside? Higher fees.
Wealthier investors may have a broker who can get access to individual issues of high-yield bonds. But be warned: That throws diversification out the window. If the issue you buy defaults, the loss could sting.