Beyond Bulls & Bears

The High Yield Leap

With nominal interest rates as low as they’ve been lately, investors seeking to capture high current income may find themselves facing an abyss. Portfolio Manager Betsy Hofman thinks the global high-yield sector can offer some compelling investment opportunities. Here’s why she thinks investors might want to consider taking the leap.

Betsy Hofman

“Currently, the benign outlook for (corporate) defaults and the healthy U.S. corporate environment have continued to make the high-yield sector an attractive option for investors, in my team’s view. Over the past few years many corporations have sought to raise their liquidity buffers and deleverage their balance sheets. This generally conservative approach to financial management, combined with earnings growth over this period, has, in our opinion, reduced the inherent financial risk in the corporate sector.”

Risk is, of course, a key consideration not only for high yield, but for any investment. In the context of fixed income investing, there really are two basic types or risk: credit risk and interest rate risk. Hofman explains.

“Of the two, many investors tend to focus on credit risk, or the risk of not getting your coupons paid and/or your principal back. However, when longer-term interest rates rise, the price for government bonds will generally move lower (and the longer the maturity of a bond, typically the greater the downward price move).

Considering the historically low rates being offered in many developed-market government bond markets (such as those of Japan, the U.S., Germany and Canada), investors are being paid little to invest in these countries’ bonds. Although we expect inflationary pressures to remain subdued over the near term, the potential longer-term impact of government debt funding needs from these countries, combined with very low current yields, does not make these fixed income sectors very compelling longer-term investments, in our view.

Accommodative public debt markets have allowed many companies to issue bonds and to push out their debt maturities, further reducing refinancing risk. Despite these supportive fundamentals, security prices in the credit markets have largely moved up and down this year based on headlines from the eurozone and the U.S., as well as from moves in the global equity markets.”

Vulnerabilities and Opportunities

Hofman recognizes the high-yield sector may be vulnerable if the eurozone sovereign debt crisis (or another market shock) increases volatility. That said, she believes the asset class can provide a lower financial market correlation relative to equities with the potential for higher-than-average yield. Franklin Templeton’s sovereign and local asset management analysts continue to identify select opportunities where they see attractive valuations on a risk-adjusted basis and below-average default rates. Where are they finding these opportunities more specifically?

“Currently, one sector we continue to favor is energy, where we feel there are good fundamentals supporting the various issuers. In addition, we also see the potential for positive event risk for these names as there have been a number of recent buyouts by cash-rich, higher-rated energy companies looking for strategic acquisitions. We also view this as an exciting time for the high-yield asset class as it continues to globalize. Recently, we’ve seen Yankee issuance (bonds issued in the U.S. market in U.S. dollars, by foreign issuers) from Europe as well as Asia and Latin America.  While the market remains modest, we believe this trend will likely continue and we expect this will continue to be an area of growth.”

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What are the Risks?

The value of investments and the income from them may go down as well as up and you may not get back the full amount that you invested. Bond prices generally move in the opposite direction from interest rates.  In general, an investor is paid a higher yield to assume a greater degree of credit risk.  High yield bonds involve a greater risk of default and price volatility than other high quality bonds and US government bonds.  High-yield bonds can experience sudden and sharp price swings which will affect the value of your investment