High-yield bonds offer compelling valuations and better fundamentals following the selloff since mid-year, Pimco said in a note Thursday with the headline "We don't call it junk anymore."
"The recent market turmoil has improved the relative value of high yield bonds and we believe provides an attractive entry point," said Andrew Jessop, a high-yield bond portfolio manager at Pimco, which has around $2 trillion under management, although Morningstar estimated it saw around $25.5 billion in outflows from open-end funds in September after storied fund manager Bill Gross left the company.
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Many analysts anticipated a selloff in high-yield bonds, also called junk bonds, as yields had become progressively less and less high – even in the face of expectations for interest rates to rise. High-yield bond mutual funds and ETFs saw net outflows of $3.69 billion over the past week and $30.73 billion over the past three months, according to data from Jefferies.
Valuations had become stretched, with the segment's yields mostly below 5 percent in June, a nearly unprecedented low, Jessop noted, but he added that yields rose above 6 percent in late September. Bond prices move inversely to yields.
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While the coupon income is likely to continue dominating the sector's performance, "with average prices just above $101, a buyer in the high yield market has potential for capital appreciation as well, if – as PIMCO believes – Treasurys are likely to remain range-bound and defaults do not pick up materially," Jessop said.
Pimco believes the quality of junk bonds has actually improved.
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"Earnings have been growing at a strong pace of 8.7 percent through the second quarter, according to all publicly reporting high yield issuers," said Hozef Arif, a portfolio manager at Pimco, in the same note. "Given the substantial decrease in interest costs attributed to low refinancing rates and the subsequent all-time high interest coverage ratios, not to mention the relatively small amount of bonds maturing over the next two to three years, we do not expect defaults to pick up in any meaningful way over the foreseeable future."
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Jessop also noted that recent high-yield issuance has also been of higher quality, with BB-rated bonds -- or the highest rated of the "non-investment grade" or speculative segment -- coming in at 60 percent of September's new issues, compared with 45 percent of the outstanding junk bonds. Several deals were pulled or postponed in September because of investor resistance to terms, Jessop said.
—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1