Talk of US high-yield 'bubble' is overdone

By Rachelle Kakouris and John Balassi

NEW YORK, March 8 (IFR) - Forget the chatter about a bubble in high-yield bond market, analysts and strategists say - all the talk looks more than a little overdone.

Yes, valuations are high, and the credit quality of new deals lately is not quite as good as previous years.

But there are growing signs that an economic recovery in the United States is gaining pace and, even more importantly, the number of defaults is still around its historic low.

"You get your true downside in high-yield when defaults are picking up," said Gary Russell, lead portfolio manager and head of high-yield bonds at Deutsche Asset & Wealth Management.

"That's the main risk and that's where the focus should be. And given where defaults are expected to go and how aggressive companies have been in pushing out maturities, I would say we are certainly not in the bubble phase."

In fact, the average implied default probability is currently decreasing.

Moody's expects the default rate to drop to just three percent by the end of 2013 - below its historical average of 4.5 percent and well below its cyclical peak above 14 percent in late 2009.

And while the high-yield index dollar price is close to its all-time high, and the yield-to-worst remains well below six percent, the asset class is still attractive relative to other fixed-income products.

"We think total return in high-yield for 2013 will be in the mid- to high-single digits, and we are certainly on course to hit that," said Russ Covede, portfolio manager and managing director of Neuberger Berman's high-yield group.

"Yields might be tight but spreads are not," he said. "We are still about 250bp from our all-time lows."

WORRY ABOUT RATES?

Normally, the credit spreads of high-yield bonds move in the opposite direction to Treasury yields, and this trend has been particularly pronounced since the financial crisis.

When risk has flared up, investors have fled to the safety of Treasuries, sending high-yield spreads wider.

In risk-on periods like the current environment, yields in Treasuries rise while high-yield spreads contract.

Some investors like Dave Breazzano, president and CIO of DDJ Capital, recommend focusing on floating-rate debt and shorter durations in order to minimize the risk from rising rates.

But even he believes the high-yield market can withstand a 50bp rise in Treasury rates - while others dismiss the rates concern altogether, particularly as the Fed maintains its low-rates policy.

"In the current low-yield environment, high-yield still serves an important role in asset allocation," said Edward Marrinan, head of US macro credit strategy at RBS.

"It should deliver solid carry - if not very much capital appreciation - with still historically low default risk," he said.

In fact, even though rates have risen overall since the start of 2013, the total return on the Barclays Corporate High Yield index is a positive 2.2% year-to-date.

Meanwhile investment-grade bonds have been faring poorly. While spreads have tightened since the start of the year, there has been a negative total return of minus 0.36% on the Barclays Corporate Investment Grade Index.

Still, the endless hunt for yield has limited capital appreciation potential for high-yield and the market is facing significant resistance below the six percent yield level.

At such an unusually low level, call restraints place stringent limits on upside potential, causing significant extension and performance risk for high-dollar priced bonds.

Although these remain important concerns, there is no pause in the market for high-yield. The technical backdrop still remains positive with Lipper reporting US$820m fund inflows into high-yield funds for the week ending March 6.

Even the potential for a gravitational pull towards equities is not a worry. Most money managers don't think it would significantly affect high-yield because investors would be selling into strength and solid credit fundamentals.

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(Reporting by Rachelle Kakouris and John Balasssi; Editing by Marc Carnegie)

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