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Varying mandates explains returns
In my last article of 2002, I opined that the bond components of portfolios should overweight corporate and high yield bonds. My call turned out to be a good one as falling interest rates and a roaring stock market have propped up the whole bond market, but particularly high yield issues. In my opinion, however, the easy money has already been made, and now investors would do well to pay particular attention to credit quality.
Market activity
Since my recommendation to overweight high yield bonds in December, corporate and high yield bonds have handily outperformed government bonds. I estimate that government bonds in the Scotia Capital Universe Bond Index have returned about 7.5 percent for the first seven months of this year, but underperformed corporate bonds by more than two full percentage points during the same period.
(Note: Corporate Bond is the term used to describe investment grade debt issued by a corporation. High Yield is corporate debt that is rated below investment grade or BBB.)
That's a substantial level of outperformance for a moderate amount of extra risk. Among the lower quality, high yield debt issues, performance was even more outstanding as the corporate and high yield bond market has mirrored recent stock market activity.
Generally, stock markets around the world have done quite well. In particular, it's the more aggressive stocks - in the information technology sector in particular - that have really put up big numbers this year. Whether you look at a U.S. comparison (NASDAQ vs. the S&P 500) or a domestic one (S&P/TSX Canadian Information Technology vs. S&P/TSX Composite), you'll find that tech stocks have outperformed the broader markets by about 20 percentage points so far this year.
Interestingly, bonds issued by tech and telecom companies are those that sported huge spreads above government bonds last fall - and that have posted enormous gains ever since.
Content differences
A look at high yield bond funds available in Canada shows wide ranging performance numbers - from the StrategicNova Canadian High Yield Bond's 18.9 percent gain to the 0.5 percent loss of CI's Signature Corporate Bond fund. Why such disparity? Differences in strategy implementation explain most of this. Let's look at two funds to illustrate this point.
StrategicNova Canadian High Yield Bond's top five holdings currently account for about 1/4 of its assets - and all are telecommunications issues. Trimark Advantage Bond (now only open to existing unitholders) not only takes a more diversified approach (top five holdings make up less than 12 percent of the fund) but the bonds it buys don't have the same level of credit risk or sector concentration. In short, Trimark takes fewer, smaller bets as compared to the StrategicNova fund.
For the past several months, the market has rewarded those taking higher risks, which explains the relatively greater success of StrategicNova. However, that won't always be the case.
Recommendation
With credit spreads having narrowed significantly since last fall, the easy money has already been pocketed in the high yield market. While funds with higher quality bonds trailed the pack in this hot market, expect them to do relatively better going forward. High yield bonds are still a good place to hold some fixed income in this low rate environment but dipping down into distressed debt may no longer hold the return potential it did several months ago.
Buying low quality debt was attractive because prices were so low it made the risk worthwhile. However, prices have risen dramatically so better values are not likely to be as common among lower quality high yield bonds. Rather, holding a fund that sticks to higher quality issues - like Trimark, GGOF, and PH&N - may be a better bet going forward (and a better diversifier versus stocks) given current valuations.