US junk bond deals whet investor appetite

A steady decline in yields at the speculative end of high yield debt suggests growing investor appetite.

A troika of conditions exist for investors interested in pursuing greater returns through US junk bonds: Treasury yields are slipping, low volatility and an equity market that held several rallies and record highs.

Yield best at bottom of the pile?

Patrick Connolly, Chase de Vere

High Yield Pullback

The BofA report considers two questions that could determine longer term positioning and whether a bearish or bullish stance will be taken.

First, the impact of political uncertainty on high yield and whether or not thre will be a replay of 2014/15 if the Trump adminstration and the Republican party are unable to deliver their agenda.

According to the report a correction may be in line with their prediction for a "strong/fiery winter and early spring should yield a total return of 4-5%, but should eventually give way to an icy back half. As the ECB's Draghi continues tapering and high yield offers less compensation, retail flows have been benign. Should they turn substantially negative, as investors depart from rich US credit in favor of other relatively safer fixed income assets, we think the market could realize a correction."

Fixed interest has historically paid a steady level of income and isn’t usually subject to significant falls in value meaning that investors’ capital should be well protected.

However, the conventional wisdom of fixed interest being low risk doesn’t necessarily work today warns Connolly. 

"As a direct result of the actions of central banks and general nervous investor sentiment, prices on many perceived high quality fixed interest assets, particularly government bonds, are looking very expensive," Connolly says.

"This means [fixed interest assets] could potentially be subject to significant falls in the future, which would be bad news for those relying on fixed interest to provide security in their portfolios," he adds.

Risk (Source: Shutterstock.com)

For a heroic strategy, buy time

This means that fixed interest is likely to be higher risk than usual and possibly much higher risk than many investors appreciate.

BofA Merrill Lynch writes, "Our bias is to reduce exposure to CCC risk and move profits into higher quality paper. In our view, investors should buy time, not be a hero, and wait out the late spring/early summer noise."

Connolly says that against this backdrop investors must be very careful. "There is a place for fixed interest investments in most investment portfolios. Particularly for the more cautious investors, those near or in retirement, or those who want to provide some protection against stock market falls."

The best investment route may be to diversify fixed interest holdings, which likely includes perceived higher risk areas such as junk bonds, which produce higher yields and have the potential to give better overall returns and can also help to spread risks.