Fed Rate Hike, What Rate Hike? High-Yield Bonds Still Attractive

 | Jun 06, 2017 | 9:00 AM EDT
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If investors are worried about the Federal Reserve's monetary tightening plans, you wouldn't know it judging by the performance of high-yield bonds.

This asset class -- also known as junk bonds because they are rated below investment grade by credit rating agencies -- sparked fears of widespread defaults in 2015, when the Fed began raising rates for the first time in almost a decade.

Fast forward a couple years and the picture looks much brighter. High-yield debt funds have seen positive inflows of capital for six consecutive weeks, according to data from Bank of America Merrill Lynch. Last week, they even recorded a significant improvement: inflows swelled from $4 million in the week before to $668 million.

With more interest rate hikes by the Fed on the way, some investors are beginning to wonder if high-yield bonds have plateaued. Bond prices move inversely to yields, and when central banks raise interest rates the yields on more speculative bonds usually fall because investors get better returns in risk-free assets and sell out of high-yield ones.

However, Scott Ellis, corporate securities specialist at Penn Mutual Asset Management, believes high-yield bonds still will deliver relatively good returns.

"Underlying credit is still strong. Companies continue to generate free cash flow. Defaults have been low and are expected to stay low this year," he told Real Money in an interview. "Companies have cleaned up their balance sheets in some of the troubled sectors, like energy and mining."

A report by rating agency Standard & Poor's shows that the global default rate for junk-rated companies increased to 4.2%, the highest level since 2009 and slightly above its 36-year annual average of 4.1%.

With global growth set to continue, companies' earnings are likely to improve while debt is not increasing too significantly, according to Ellis. His strategy is to focus on higher-quality names in the space, generally the ones that are rated BB.

"If you look at CCCs, I think the default rate is one in every four; for double Bs it's a much lower percentage, historically in the single percentages," he said. "We think there's more value in the BBs. We look for credit stories that still have catalysts to improve and even have the ability to go investment grade."

Ellis' strategy is to look for companies that have "a willingness and ability to improve their credit story." He looks at whether the companies have a strong asset base, strong cash flow or hidden assets on their balance sheet.

There has been a lot of merger-and-acquisition activity, and if this continues it will increase the supply of debt to the market as companies use debt to finance their acquisitions. This situation could weigh on bond prices because there will be more bonds for investors to choose from, but on the other hand it could act as a catalyst for the market.

If a company's existing bonds are not that liquid, a new issuance sometimes can buoy them by refreshing or renewing the company's story in investors' eyes, especially if the issuance is used to finance a merger.

"If the market likes the acquisition, that can be a catalyst in and of itself. There's a lot of money that people are trying to put to work. The primary market (for bonds) can be a good way to allow that to happen," Ellis said.

The energy sector has good M&A potential, as it is still fragmented, in Ellis' opinion. Investors can find companies with strong assets but weaker balance sheets in energy, and this could prompt companies with debt rated investment grade to buy junk-rated ones.

There are, of course, risks for investors in high-yield debt. A hard landing in China and political uncertainty everywhere are just two of them, according to Ellis. Plus, expectations for infrastructure spending and tax cuts already have been priced into the market.

Still, judging by the level of M&A activity in the first half of the year, managers "seem willing to be betting on the future growth of the economy," Ellis said.

Will investors follow?

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