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The junk bond market: How hot is too hot?

There's no doubt that Canada's high-yield bond market is booming. There is a question, though, about whether this is the right time for investors to jump in.

The sector has delivered spectacular capital gains since the dark days of early 2009 when investors shunned risk, sending the price of so-called "junk" bonds tumbling and boosting yields to double-digit highs.

Today, the pendulum has swung. With investors stretching to find dependable streams of income in a time of ultra-low interest rates, the prices of speculative bonds have shot up while yields have declined.

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Some professional investors say they won't touch high-yield bonds at this stage of the business cycle, because they believe the extra income they gain from these securities doesn't provide adequate protection against potential losses.

"Early in 2009 it was like being in a candy store. I could buy anything I wanted at any price," says John Carswell, president of Canso Investment Counsel Ltd. "Right now everyone is buying, so we are actually lightening up our below-investment-grade holdings considerably."

One of his concerns is that today's high-yield bonds are deeply "subordinated" to other debt, giving lenders little protection if the issuer of a bond hits a rough patch and defaults. In that case, banks and other investors will get their money out of the company before the junk bondholders.

In addition, many current deals allow borrowers to "call" the bonds within five years, purchasing them from bondholders at prices that are below today's levels. That capital loss will eat into the returns from yield.

'Naive Money'

"The deals that are done at the top are usually the worst deals," Mr. Carswell says. "There is a lot of naive money chasing after yields."

But bond managers say high-yield bonds remain attractive, thanks to today's low default rates and investors' appetite for higher streams of income than they can get from safer investments.

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High-yield bonds pay more in interest than investment-grade bonds because they carry a higher probability of default. To compensate investors for the added risk, high-yield bonds pay four to five percentage points above government bonds. Barclays Capital High Yield Bond ETF, for example, has a 7.3-per-cent yield to maturity.

The challenge is making sure that the extra yield provides an adequate buffer against possible losses.

Adrian Prenc, vice-president at Marret Asset Management Inc., says he is limiting his purchases of speculative-grade debt to those with the highest credit ratings. He is moving cautiously because of concerns about the outlook for the global economy. But so long as the economy continues to crawl ahead and interest rates remain low, he believes default rates on junk bonds will stay low and the securities will provide an attractive alternative to stocks.

"We're coming off a time where a lot of debt has been issued and you have to be careful about who is issuing this debt," adds Gregory Kocik, a managing director with TD Asset Management Inc. But on the whole, the credit quality of companies looks quite strong after the recession, he says.

So long as GDP growth remains above 1 per cent a year, default rates tend to stay low, Mr. Kocik says. "The environment for defaults is manageable."


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In the short term, high-yield bonds are more volatile than investment-grade bonds and government debt, he acknowledges. However, over a 10- to 15-year period, the latter two classes are more volatile because of the cycle of inflation and rising rates. High-yield debt, he says, is "in the middle of the volatility range between equities and government bonds."

The outperformance of junk bonds over government bonds is measured by the difference between their yields and the net loss from defaults, says Rex Chong, vice-president of investments at Invesco Trimark Ltd.

Historically, about 4 per cent of speculative-grade bonds default each year. When a default does occur, the average recovery is 35 cents on the dollar. In total, the net loss in a typical year on a portfolio of high-yield debt is 2.6 per cent of the original investment, he calculates.

At today's rates that means high-yield investors are likely to wind up with a return that is one to three percentage points above 10-year government bonds, even after defaults.

But other factors must be weighed, as well. Retail investors typically invest in the high-yield sector by buying a mutual fund. However, management fees that frequently exceed 2 per cent, as well as unfavourable tax rules, can quickly eat into returns.

Another factor working against the investor at the moment is the strong demand for more high-yield bonds, which is allowing issuers of the bonds to push the envelope in terms of the debt covenants that they are willing to consider. Covenants put limits on the actions of the issuers - forcing them to keep their borrowing within certain limits, for instance.

As covenants grow less restrictive, portfolio managers must buy more selectively or sit out of deals altogether.

"Right now I would say it's an issuer's market rather than an investor's market. Covenants are less onerous on the borrowers," Mr. Chong says.

High-yield bonds

Total amount raised in the Canadian high-yield bond market in 2009 and 2010: $6.7-billion

Amount expected to be raised in the Canadian high-yield bond market in 2011: $6.1-billion

Percentage year-to-date return of the benchmark Merrill Lynch high-yield bond index: 6

Percentage year-to-date return of the S&P/TSX equity index: 1.9

Source: CIBC World Markets, Globe Investor

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