High Yield Bonds Stage a Comeback

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September 14, 2009

Mark Vaselkiv, portfolio manager of the T. Rowe Price High Yield Fund, takes a look back at how junk bonds fared in the first half of the year and offers an outlook for the future.

In 2008, high yield bonds suffered their worst year in the history of the asset class—the J.P. Morgan Global High Yield Index* declined 26%. However, the market staged a turnaround in the first half of 2009 as the benchmark surged 30% in the six months ended June 30, 2009.

Dour economic conditions in 2008 set the stage for a rally in 2009.

As the financial crisis deepened toward the end of last year, the junk bond market was trading as if the economy was headed for a depression. Yield spreads over Treasuries with comparable maturities widened to record levels of about 19.25 percentage points (or 1,925 basis points)—more than triple the historical average.

More than 80% of high yield securities were trading at distressed levels, indicating that they had a high probability of defaulting or restructuring.

Why was the high yield market able to stage such a large turnaround?

Record-high yields attracted droves of investors. In the first half of 2009, the junk bond market had an unprecedented amount of new cash flow into the asset class. Even weaker companies were able to refinance their maturing debt—we call this ability to roll over maturing debt “lengthening the runway.”

High yield bond issuance surged. The improved liquidity, along with the stock market rebound, has been a catalyst for stellar gains in many depressed high yield bonds with near-term maturities, as well as the new bonds issued to refinance the maturing debt.

A legitimate case can be made that the economy is turning.

The high yield market is suggesting the recession is over. We’re seeing a massive recapitalization of distressed balance sheets.

Creditworthiness within the high yield market can be described as weak and fragile, but the possibility of bankruptcy for many companies has dropped dramatically.

Current yields of 9% to 10% for high yield bonds compensate investors for credit risks, and there is still the potential for capital appreciation as the economy improves.

The frantic selling we saw in late 2008 has passed. It has been replaced by sophisticated, courageous investors who seized a major buying opportunity in good companies trading at distressed values. We believe that positive cash flows will remain a huge catalyst over the longer term.

While we believe the pace of recent gains is unsustainable, we see positives.

The T. Rowe Price high yield team thinks the pace of gains enjoyed by the high yield market in recent months is unsustainable. However, there are several factors working in favor of the asset class.

First, we see the inflows of new money and increased refinancing activity as a positive for the market. As money flows into the asset class, it can be used to do more deals and that benefits junk bond prices.

Next, we see improving earnings for many companies in higher-quality segments. The increased cash flow is allowing companies to repair their balance sheets, which is in part due to effective expense controls that have lowered operating costs.

What is the future outlook for high yield bonds?

We think investors can still expect to generate a solid income stream and moderate capital appreciation. Because investors are becoming more risk tolerant, they are increasingly willing to own and embrace the attractive yields in the high yield market. Many companies that need to recapitalize will get the needed funding and that can generate more gains. We also believe that defaults will be lower than many forecaster’s dire predictions. Although we can’t be sure, the trend is very promising.

Finally, high yield cycles have tended to be durable and generally have not ended after a six-month period of good performance. Previous cycles have historically lasted from four to six years. We saw a strong six-year stretch from 1991 to 1997, and, more recently, the asset class generated good results from 2002 to 2007. We think that, at least for the time being, the trend is our friend.

*J.P. Morgan Global High Yield Index: Tracks the performance of domestic and overseas noninvestment-grade corporate bonds; all are denominated in U.S. dollars.

Companies issuing high yield bonds are not as strong financially as those with higher credit ratings, so the bonds are usually considered speculative investments. These companies are more vulnerable to financial setbacks and recession than more creditworthy companies, which may impair their ability to make interest and principal payments. In addition, the entire junk bond market can experience sudden and sharp price swings due to a variety of factors, including changes in economic forecasts, stock market activity, large sustained sales by major investors, a high-profile default, or a change in the market's psychology. Past performance cannot guarantee future results.