Be Careful with High-Yield Debt

I’ve seen a lot of press recently about money managers being successful owning high-yield debt over the last year, at this point in the business cycle.  High-yield bonds typically do well during an economic recovery as cash flows improve and investors are comfortable taking on more risk.  However, as I have written before, there are a plethora of risk factors on the horizon that could impact high-yield investments.

Owners of junk bonds need to be careful as to what they own and be sure in their timeframe for ownership.

High yield usually acts more like an equity than a fixed-income investment.  Since the creditworthiness of the issuing entity is in doubt, hence the low rating, investors are much more concerned with the viability of the company and its cash flow projections than the rate of interest paid.  There is also the point of refinance risk -- usually, a company issuing high-yield debt cannot just pay off the principal at maturity of the bond, but rather must refinance.  If credit is tight at that point, the entire future of the company is in question.

The equity and bond markets in general must navigate a possible rise in interest rates at some point in the future. The Fed cannot keep rates low forever.  In addition, the Fed cannot continue to print money through its quantitative easing program forever.  So a rate increase and an end to QE is on the horizon. It remains to be seen if the markets will take these events as a negative or a positive.

In speaking with several contacts on different high-yield desks on the Street recently, it seems that the smart money in this space is starting to look for security over spread.  In other words, they are focusing on getting paid back versus how much return they can expect.  The high-yield market is becoming a buyer's market.

High-yield bonds sales have pulled back as the Street is seeing a pick up in loans, or secured lending.  So as the articles on high yield debt start to populate investment websites, the smart money is taking cash off the high-yield table.  I can envision bond salesman across Wall Street picking up the phone to call the Mom and Pop investor to unload these positions.  Retail on line one!

It’s possible that from here on out, only the safer high-yield bonds will continue to do well.  Typically, if the market pulls back, high yield will wait and hold its own as the equity markets sell off.  But if there is a major economic slowdown, a repeat of what we saw in the first quarter, high yield could see a major cyclical selloff.  That would be the time to buy junk bonds.

My point is be careful with high yield.  Understand the risks.  For instance, when does the company need to refinance?  Can it cover future debt service costs?  Does it have any interest rate risk exposure?  Are you getting compensated for the risk through the return expected?  In this environment, high-yield investors need to do their homework.

L. Todd Wood is a former emerging markets bond trader.  His thriller novel, Currency, deals with the consequences of overwhelming sovereign debt.