Just as hopeful prospectors venture back to abandoned gold mines in California, so fund managers are engaged in a similar quest to find overlooked nuggets in the global junk bond market.
Junk bonds, which are sold by companies with more fragile balance sheets and a higher probability of default, have become one of the most popular securities among investors in the past couple of years. This “gold rush” has been fuelled by central banks in the US, UK and Japan, which flooded the globe with easy money and brought benchmark rates to record lows.
Lured by the higher returns and low corporate default rates, investors have lined up in scores to buy record amounts of the securities, which in turn have been sold at increasingly higher prices and with looser standards of protection for the lenders.
The junk market has now reached a lofty level in terms of valuation, raising concern of an asset bubble in some quarters, but some fund managers and analysts say there is still more to be mined, so long as investors know where to look.
“The game has changed in the high-yield market and it has become more sophisticated than it was two or three years ago,” says Sabur Moini, a high yield fund manager at Payden & Rygel.
“You have to keep asking yourself how much more extra ‘risk’ you want to keep adding to your portfolio in order to keep the same level of returns.”
Such a call is now at a crucial stage given the blockbuster five-year rally that has driven average junk bond yields down from a financial crisis peak of 22.9 per cent to 5.2 per cent on Monday, according to Barclays.
Another challenge for investors seeking bargains has been a recent move in risk premiums – the spread between yields on the bonds and those of comparable US Treasuries. The current low risk premium provides scant protection for investors to absorb the impact of a potential back-up in interest rates.
Average spreads on high-yield debt over Treasuries stand at 352 basis points, according to Barclays. That marks the lowest risk premium for investors owning junk debt since 2007.
“There are segments of the high-yield market that do not compensate you for the risk you are taking by owning them,” says Michael Fredericks, portfolio manager at BlackRock. He says investors buying triple-C rated bonds are looking to own them for a couple of years and then get out before the credit cycle turns.
The low corporate default rate of 2.3 per cent is almost half the historical average, according to Moody’s. In turn, money keeps being pushed into the market, maintaining pressure on managers to keep prospecting for relatively undiscovered bonds.
Last month alone, high-yield mutual funds had net inflows of $1.5bn, according to Lipper, taking year-to-date inflows close to $3bn.
Brad Rogoff, head of credit strategy at Barclays says investors may still find value in high-yield bonds sold by US companies in sectors such as mining and retail.
Year-to-date returns on those two groups, at about 1.9 per cent, have so far lagged behind those in the broad market, at 3.2 per cent, according to Barclays.
Dollar bonds sold by European companies are another attractive area, says Mr Rogoff. The European “yankees” are on average cheaper than the broad US high-yield market and in addition, issuance of new bonds is likely to be muted in 2014.
A further option is looking at emerging market high-yield paper that is still attractive in terms of valuations relative to US peers. Average yields on emerging market companies with ratings below investment grade, stand at 7.6 per cent, according to JPMorgan indices.
“It’s definitely one area to look at, but only if you are willing to do your due diligence because there have been examples of some big blow-ups,” says Mr Moini at Payden.
But some managers warn that no matter how deep investors go “prospecting” in the junk bond market, at this stage of the rally, the potential for high returns is limited.
Portfolio decisions “should now be guided by avoiding the losers as much as by picking the winners”, Pimco said in a note to clients. “There are few total return opportunities still available to offset any potential widening in yields and subsequent underperformance from deteriorating credits.”
The great California Gold Rush attracted over 300,000 people to the gold mines and surrounding cities between 1849 and 1855. But most of the fortunes were made in the first months of the rush, with many late prospectors losing money.
“We are at a very late stage in the high-yield rally,” says Michael Kastner, principal at Halyard Asset Management. “But people chasing yields look at how well these bonds did in the last couple of years and assume they can replicate that.”