Buy Side Warns On Higher Yields

Terry Flanagan

With U.S. 10-Year Treasuries hovering at barely above 2%, institutional and individual investors alike are searching for yield by moving down the credit scale.

Yet, a plight to chasing yield by moving out on the yield curve should not overshadow basic portfolio theory, according to Jim Barnes, vice-president and senior fixed income manager for institutional advisors at National Penn Investors Trust. The firm manages approximately $1 billion in fixed income assets and serves high net-worth individuals, as well as endowments and foundations.

Barnes is currently seeing increased interest in high-yield bonds, which are often looped in the same category as equities when it comes to higher return generation.

“High yield makes sense, but only if the risk tolerance of the individual or institution warrants it,” Barnes told Markets Media, and cited the persistent inaction within cash markets has pushed people into riskier assets. Since January 2008, interest rates have fluctuated from 3.5% to below 2% and back to slightly above 2%.

Endowments and foundations are especially back to championing riskier assets given that their harrowing days of 2008 are long past.

“Endowments and foundations are more comfortable with taking risk on again, going back to the days before 2008,” said Barnes. “There’s a place for high yield in original allocations, given their non-correlation benefits in a portfolio, but we’re strongly against resorting to trading high yield because you don’t like other options.” Junk bonds have returned 5% year-to-date, cited The Wall Street Journal.

Institutions have long been catapulted between the fear and greed pendulum. For Barnes, it’s best to stay in fear mode when it comes to high yield instruments because “people tend to lose sight of the volatility, and just focus on their potential return. If the risk profile of a client has not changed, despite the over-arching macro environment, clients should take a step back and reassess their allocations,” he said.

With higher demands for high-yield fixed income, comes higher demand for liquidity. That, of course, means a spur in investment vehicles such as exchange-traded funds (ETFs) and high yield bond mutual fund offerings.

Thus far in 2012, high-yield themed bond and stock mutual funds categorized as “junk” and related ETFs have taken in more than $17 billion in new capital, according to the Wall Street Journal. Approximately 15 cents of every new dollar flowing into all stock and bond funds combined has gone into junk grade investments.

The junk craze may have led to some mis-pricing and overvaluation of high-yield securities, according to some market participants, though bond ETFs have always traded at a slight premium given they provide more liquidity for investors and are easier to trade as a basket of securities than a multitude of individual bonds. High-yield debt ETF demand has come from individual investors who would otherwise have trouble gaining access to bond issuances in the primary market.

Structured products, especially leveraged ETFs that may fall into the junk bond category, have often always been casted as dangerous territory for investors. Barnes, however, told Markets Media that “any product out there that attempts to provide more liquidity is a good thing…as long as it makes sense for your portfolio”.

Two high-yield ETFs, iShares iBoxx High Yield Corporate Bond HYG +0.24% and SPDR Barclays Capital High Yield Bond JNK -0.05% have collectively experienced inflows of nearly $6 billion between them, contributing to a 34% increase in high-yield assets since year-end 2011.

As markets continue to tepidly improve, Barnes stresses the need to keep higher grade products in his clients’ portfolios. Despite efforts to make high yield a more liquid arena, liquidity can always be found in Treasuries, and perhaps, increasingly, with corporate bonds.

Within the corporate bond arena space, bid/ask spreads have been reduced considerably, which has been “good for the investor”, due to new price reporting systems, such as Trace [Trade Reporting And Compliance Engine], noted Marshall Nicholson, managing director at Knight BondPoint, a provider of electronic fixed income trading. Yet, Nicholson told Markets Media that “others will argue that secondary market liquidity has been impacted in the corporate bond market as dealers are less willing to commit capital as the returns for doing so are less attractive since the introduction of Trace, which is bad for the investor”.

While demand for junk has increased in a yield-parched investment environment, demand for investment grade corporate has risen to match.

“The main thing we can expect from the corporate side is that people will continue to look to the corporate bond market as an alternative to volatility in the equity markets,” said Chris Shayne, senior market strategist for fixed income brokerage BondDesk. “Demand for corporate bonds will remain fairly strong. Credit worthiness of corporate bonds is reasonable now, so people looking at corporate bonds as an investment opportunity can do so with confidence.”

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