Junk-bond rally may be near its end

High-yield credit has so far been one of the best bets of the post-financial crisis era, but the impressive rally in socalled junk bonds may be near its end, say analysts.

“The high-yield market has been such a great place to invest that it has generated a total return of 131% over the past decade, far outpacing investment grade credit which itself generated a decent 69% total return,” said David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates Inc., in a note to clients Thursday.

“The question from here is how much juice is left, with average yields in the HY market now barely above 5% (versus 5.8% a year ago even with the rise in treasury yields).”

One of Mr. Rosenberg’s concerns is the seemingly unfettered enthusiasm for highyield credit, which has resulted in almost US$3-billion in net flows to related mutual funds and ETFs in the past three weeks. He also noted the growing appetite for low-grade CC-rated debt, and a recent S&P estimate that forecasts a corporate default rate of 2.5% by year-end. That figure is still low compared with the longrun average of 4.4%, but it represents a solid increase from the current default rate of 1.7%.

Arthur Salzer, chief executive at Northland Wealth Management in Markham Ont., is even more bearish, saying the very high spread between equities and high-yield debt is pushing valuations of the latter to record highs.

“Should interest rates begin to rise, the interest rate protection that has historically been provided by the highyield market will likely prove to be substantially less than previous experiences,” he said. “We see the high-yield market as being very expensive at this point in time, although we do not expect a large sell-off in the near future.”

As such, Mr. Salzer has been reducing his client’s exposure to the high-yield market with the goal of eliminating it entirely, and replacing it with Canadian dividend-paying equities as well as private mortgage pools.

“Given the recovery that is occurring in the real estate market south of the border and that loan-to-values are at a maximum of 65%, we see the investment in this area as having better risk versus return than high-yield bonds at this point in both the short and long term,” he said.

Despite such growing pessimism, Aubrey Basdeo, head of fixed income at BlackRock Canada, thinks there’s still a place for high-yield debt in many investment portfolios. He is also watching default rates closely, but thinks the improving economy south of the border and

We see the high yield market as being very expensive

elsewhere around the world should keep them from rising dramatically higher.

At the same time, he said high-yield fundamentals remain strong, because corporations have plenty of cash on hand and the U.S. Federal Reserve’s monetary policy remains highly accommodative despite the tapering of its bond-buying program.

He still likes the play, but he views it as more of a source of income than one that will see a lot of price appreciation, because spreads have already tightened 200 basis points so far this year.

“Quite frankly, investors are still looking to add more yield in this low-interest-rates-for-longer environment and for that reason high yield still plays a role,” he said.