04.18.2012

Reaching For High Yield

04.18.2012

In the current low interest rate environment that’s been propagated by central banks for the past few years, achieving yield with low risk and moderate portfolio volatility is a feat left for the likes of David Copperfield.

Increasingly, institutional investors are beginning to flock to high-yield corporate credit instead of equities and other asset classes. Wobbly markets across the globe and the uncertainty surrounding the Eurozone crisis have hurt equities and increased volatility while also driving up the price (and thus, lowering the yield) on U.S. Treasuries.

So the question becomes: how do you achieve returns with moderate-to-low volatility in the current investing environment? The answer lies within corporate credit. Companies are sitting on mounds of cash and are continually beating Street expectations on earnings and driving their prices higher. Corporate high-yield debt beats out returns on investment-grade corporate credit and Treasury debt while keeping volatility below U.S. stocks, German stocks and precious metals.

“We are very constructive on 2012. The risk has come down quite a bit in the short-term, but there are still uncertainties,” noted James Keenan, managing director and head of leveraged finance at BlackRock. “That said, we have accommodative policy now from both the US Fed, which recently said rates would remain low through 2014, and from the ECB…absent Europe, conditions are quite favorable for high yield investing”

Since the financial crisis of 2008, companies have worked hard to reduce debt on their balance sheet and have refinanced existing debt and other obligations. Decreased leveraged over an extended period of time has kept companies healthy and nimble. The current average yield in the high-yield market is now around 7.9% with an 8.25% coupon according to research from BlackRock. Investors will be hard pressed to get those kinds of returns from any other debt-focused asset class.

Default fears persist but currently, the rates are low, garnering a number of around 1-2%. Defaults are expected to pick up in number over the next five years but will be limited to companies that are dying out due to technology or efficiencies in industry.

“The market is pricing in much higher defaults than we believe we’re likely to see,” said Keenan. “At today’s levels, markets are pricing in 5.5% to 6% defaults at a target return of 300 basis points over Treasuries, and the breakeven default rate is over 13%. So, bottom line: high yield is a value today in terms of the income you’re getting for the risk you’re assuming.

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