High-yield bonds are risky even without a bubble

Wheat field1Market watchers who predict a bubble in high-yield bonds are exaggerating the risks, say analysts at AllianceBernstein – but investors could still lose money unless they are cautious.

High-yield bond funds tracked by data firm EPFR Global took in $615 million (€451 million) in the week ending January 23, crowning a run of inflows that led some commentators to warn the asset class was dangerously overvalued.

Critics of the bubble theory will say it is wrong to talk of a bubble because the known ending values of high-yield bonds give investors an incentive to hold them even if there were a sharp sell-off.

However, there is a risk that the run of inflows has brought into the market more low-quality issuers, which present a greater risk of default.

“Many recent new issues are from weaker CCC companies that might have never been able to get financing without the increased demand of late,” says Ivan Rudolph-Shabinsky, fixed income portfolio manager, AllianceBernstein.

On average, more than half of CCC issuers default over a five-year period, which means investing in bonds from these issuers is risky.

“Investors need to be very judicious in their security selection,” says Rudolph-Shabinksy. “While many CCCs will generate attractive returns, many others will likely be disappointments.”

Analysts are concerned that the rise in inflows has depressed returns on high-yield bonds, meaning investors can expect less reward for their risk. Rudolph-Shabinksy estimates a 6% average yearly return in the next five years.

As with other risky investments, prices of high-yield bonds would be likely to fall if the economic situation worsened, with the added complication that defaults would be likely to rise.

However, the markets may already have responded to the less optimistic outlook for the asset class. In the last week of January, the tide of inflows shifted from high-yield bonds into funds that invest in floating-rate corporate loans from banks and insurance companies.

“Flows into floating rate funds for the week were a record-setting $1.12 billion, almost double the amount absorbed by high yield bond funds,” wrote EPFR Global.

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