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High-yield debt: The best of bonds and equities Add to ...

Albert Einstein referred to compound interest as the eighth wonder of the world. Unfortunately for investors, interest is currently compounding at rates close to an all-time low. Five-year government bonds in both Canada and the United States currently yield a mere 1.5 per cent, which is 0.5 per cent below the current rate of inflation. Investors in high-quality bonds are actually losing money on their investments in real terms.

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Many investors have responded by increasing their exposure to equities. However, this increases risk as well as volatility, to uncomfortably high levels for investors who prefer a more balanced approach.

This is the conundrum facing investors today. Government bond rates are now at their lowest level since the 1930s. Equity markets may offer inflation protection, but are inherently volatile and do not offer stability of income.

Is there a better alternative? The high-yield bond market can offer equity-like returns with less volatility and is an excellent alternative for those investors not wanting to overweight the equity component of their portfolios.

High-yield bonds are issued by corporations that are rated below investment grade (anything lower than Triple B-minus). They are issued with a higher coupon than investment-grade bonds to compensate for the extra risk. While the risk of investing in these bonds may be higher, it can be mitigated by investing in a well-diversified, global portfolio of high-yield bonds.

The pickup in yield is substantial. The yield on the JPMorgan Global High Yield index is 5.6 per cent, which is roughly four percentage points higher than the yield on a five-year U.S. Treasury bond.

As with equities, high-yield bonds present the possibility of capital gains as the issuers’ credit profile improves. Unlike equities, however, bonds have a maturity date. A company’s stock price can fall dramatically, but so long as it is able to pay its bondholders at maturity, the bond investor will earn the expected return. It is simply a game of survival – if the company survives to the maturity date, you win. Bonds also offer protection by being more senior in the capital structure, giving them a call on the assets of the company that equity investors do not have.

It is worth pointing out that, while counterintuitive, high-yield bonds have historically outperformed other asset classes in a rising interest-rate environment; an environment that is currently a focus of attention due to the Federal Reserve’s bond-buying reductions. Rising interest rates are often the result of an improving economy. While prices of government and investment-grade bonds fall with rising interest rates, high-yield companies’ credit profiles strengthen during an improving economy. This also reduces the premium they require over investment-grade yields and makes their price movements far less volatile.

Investing in a fund is the only sensible way most individual investors can safely participate in high-yield bonds, as diversification is important and these bonds tend to trade in million-dollar units. The Canadian high-yield market of approximately $10-billion is dwarfed by its U.S. neighbour (which is worth more than $1-trillion), and its industry concentration is too thin to offer any real diversity. Exposure to the U.S. or global high-yield market is essential.

High-yield bond portfolios require dedicated management and expertise to effectively manage interest-rate risk and evaluate the credit risk, covenants and collateral associated with each bond issuer. The process requires a great deal of time and skill, but when managed properly, high-yield bonds can add value to any portfolio and investors can sleep well at night knowing their equity exposure is not higher than desired.

When choosing a fund, investors should pay special attention to the credit quality and duration of the portfolio. It is also important to evaluate the track record and experience of the fund managers, whether or not there is a hedging strategy in place for foreign currency and how diversified the fund is in both number of holdings and across sectors. Management fees and other charges, which are not always transparent, are also an important consideration.

Apart from our own proprietary high-yield fund, the Steinberg High Yield Fund, other financial institutions managing high-yield funds include Phillips Hager & North, SEI, Chou Associates Management Inc., CI Investments and Manulife Mutual Funds.

Geoffrey Smith and Brian Pinchuk are portfolio managers of the Steinberg Funds.

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