Why low bond yields are all you deserve

Leslie Shaffer | Writer for
Are low bond yields justified?

While bonds' low spreads over Treasurys have spurred concerns investors may be paying too much for yield, some analysts say low payouts may be justified.

Bonds' spreads and yields are "fairly priced," said Steve Goldman, managing director at Kapstream Capital, which has around $5.6 billion under management.

"You still get paid to take the default risk inherent in both investment grade and high yield bonds because default rates are incredibly low," he told CNBC. "To the extent that you're getting yield premiums over risk-free assets like government bonds, it's worked out pretty well for investors over the last four to five years."

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With easing programs coming from central banks globally, bond yields in general have hovered around historic lows sending investors searching for better returns by loading up on riskier debt, tightening spreads with benchmark 10-year U.S. Treasurys, which are yielding around 2.58 percent in Asia trade Monday.

Barclays Capital High Yield 100 index is yielding around 4.39 percent, down from its 52-week high of 6.35 percent, while the broader Barclays Capital Aggregate bond index is yielding around 2.29 percent, down from its 52-week high of 2.68 percent. | age fotostock | Getty Images

At the same time that investors are being paid less to take on risk, bond default rates are falling.

Moody's 12-month trailing global speculative-grade default rate came in at just 2.3 percent in May, equivalent to two companies defaulting in the month, down from a 2.8 percent rate at this time last year. Moody's expects the global speculative default rate will fall to 2.1 percent by year-end and then rise to around 2.4 percent a year from now.

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Kapstream's Goldman isn't alone in believing yields may be fairly priced.

"It's as good as it's ever been in terms of defaults," said Campbell Dawson, director at fixed income manager Elstree Investment Management.

"With two to three years of really low default risk, even though the investment is expensive on historical terms, you're still going to make money," he said, noting that forward-looking models put default rates at the lowest since 1990.

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To be sure, there are concerns over whether default risks will remain low as more marginal issuers head to the market.

"The quality of the issuance is going down," Kapstream's Goldman said. "It's not the same securities as they were a few years ago. The bond covenants are much weaker today than they were in the past."

Covenants are restrictions on borrower behavior, such as limits on the amount of debt a borrower can take on.

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"There are a lot of worse deals coming out there that maybe you aren't getting paid to take that default risk and that'll be a problem for the future," he said.

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Goldman is particularly worried about "pay-in-kind" deals where issuers which don't have the cash to make their bond coupon payments can instead pay in equity.

"Those types of deals are increasing in today's world in the search for yield. That would be one of the signs that issuing standards are going down, that investors would accept those deals," Goldman said.

Dawson is also concerned the quality of fresh bond issuance is declining.

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"Clearly, the number of covenant light loans have gone through the roof and covenants have become lax," Elstree's Dawson said, although he noted that some research indicates that covenants don't have much effect on whether a high-yield issuer defaults.

But he added, "When U.S. rates start rising, that's when you'll start to see more default activity," with the potential for "a really nasty cycle" to emerge.

Dawson is most concerned about the high level of leverage that some companies are taking on, with lending of as much as eight times value in the high-yield market.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1