Are High-Yield Bonds in a Bubble?

Income investors are now getting the very last message they want at a time when the hunt for yield is so frustrating because US government bonds pay so little, or nothing at all, after inflation.

Commentators are throwing around the dreaded "B word." As in, high-yield bonds are in a bubble. Yikes.

Getting a mere .7% yield on a 5-year US treasury bond is bad enough. But who wants to be the person who buys an asset class, high-yield bond, when it's in a bubble?

Well, calm down. The high-yield "bubble analysis" is incorrect because it's way too superficial, believes one bond fund manager who is well worth listening to since his fund has handily beat competitors for the past five years.

"I don't believe we are in a bubble," says Paul Ocenasek, who co-manages the Thrivent High Yield Fund (LBHYX). The fund has bested competitors by 1.37% per year over the past five years, according to Morningstar, by returning an annualized 8.4% per year.

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The bubble crowd is going off the tracks by merely looking at yields in isolation, pointing out that the Barclays Capital High Yield Bond Index now pays a 6.8% yield, which is about as low as it's ever been. This means, in their view, that high-yield bond prices are so exceptionally high, and thus the yields so low, that they have to be in bubble territory.

But as with anything in the markets, context is key. And the context here shows that the 6.8% yield doesn't really prove that high-yield bonds are in bubble territory, reasons Ocenasek, whose Thrivent High Yield Fund has returned 10.7% to date, and currently yields 7%.

First, consider the high-yield spread over the yield on 10-year treasuries. At 5.7 percentage points, it is above the long-term average of 4.7 percentage points. In other words, it is not nearly as low as you would expect it to be in a high-yield "bubble." High-yield spreads over treasuries decline, signaling a possible bubble, whenever high-yield bonds are bid up relative to treasuries. That lowers returns on high-yield bonds and narrows the spread. But we don't see that now. And that 5.7 point spread is not even nearly as low the spread you see during high-yield bull markets. That spread was a mere 2.7 percentage points during the 2007 bull market in high yield.

Next, that spread to treasuries is actually pretty high, historically speaking, given the low default rates on high-yield bonds. The default rate is now at 2.5%, says Ocenasek, compared to a long-term median of around 4%. Given the historically low default rate, the high-yield spread over treasuries should be more like four percentage points, instead of the current 5.7, he says. "The spread is above its long-term average, and the default rate is below its long term average," says Ocenasek. In short, not the stuff that bubbles are made of.

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If you buy it, here are four of Ocenasek's favorite high-yield bonds at the moment. They all pay a decent yield. They're all liquid because they were part of a big bond issue. And the companies behind them all look reasonably safe, which means the default risk is very low.

Limited Brands (LTD) bonds maturing in February 2022 with a 4.9% yield. That's a pretty nice yield, but it's about to get nicer. Ocenasek believes Limited Brands, the company behind Victoria's Secret and Bath & Body Works, is strong enough financially that these bonds will get upgraded soon. That would drive up the bonds, benefiting anyone who buys them now. Why the upgrade on the horizon? Ocenasek points out that Limited Brands has relatively low debt levels of just 22% of enterprise value; solid free cash flow of about $840 million per year; $1 billion in cash and a $1 billion revolving credit facility; and no near-term debt maturities. "Limited Brands is looking more and more like an investment grade company," says Ocenasek.

Community Health Systems (CYH) secured bonds maturing in August 2018 with a 4.5% yield, and Community Health senior bonds maturing in November 2019 with a 6.25% yield. Community Health looks reasonably safe because it has $450 million per year in free cash flow. It owns most of its hospitals and has a fairly stable revenue base since economic conditions don’t affect its business as much as other kinds of businesses.

Sprint Nextel (S) bonds maturing in August 2020 with a yield of 6.75%. These bonds are a little riskier than the ones above because Sprint Nextel has very little free cash flow. It has to spend a lot to maintain and upgrade networks to stay competitive. On the bright side, the pain from an ill-timed purchase of Nextel is in the past. Sprint has a four-year contract to sell the popular iPhone. And revenue growth has been in the 5% range for the past few quarters. "We are confident they are going to be around for years and years," says Ocenasek.

Of course there are risks with high-yield bonds -- even if they're issued by relatively safe companies, like the ones above. A big risk is inflation, which may well be on the horizon, given all the stimulus pumped into economies around the globe. Inflation, or better economic growth, may well send interest rates higher, which is bad for bonds, of course. "But high yield will absorb that better than any other type of bond," believes Ocenasek.

The other cautionary note here is that while high-yield bonds may not be in a bubble, yields are so compressed that there's not much room left for high-yield bond price appreciation from here, believes Ocenasek. "Capital appreciation is pretty much played out. There is not a lot more upside," he says.

On the other hand, there's not a lot of potential downside in high-yield bond prices, believes Ocenasek. That would change, of course, if we move into a recession, which typically tanks high-yield bond prices. While that's a risk, I don't see it in the cards right now, and neither does Ocenasek.

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