Manager Views

“If we return to some sort of sense of normalcy in terms of risk premiums or spreads, the upside potential on high-yield corporate bonds for the next 10 years is going to be tough to rival.”

- Dan Bastasic, portfolio manager, Mackenzie Sentinel Corporate Bond Fund

Inside corporate bonds

Equity markets tend to get all the press in good times and bad. In this Manager Views, we look at high-yield corporate bonds. Corporate bond funds generally have higher volatility than regular bond funds, but they have the potential to generate higher returns.

What are high-yield corporate bonds?

High-yield bonds are corporate bonds with a credit rating below BBB. About 25% of corporate bonds are considered high-yield. They offer higher interest rates than government-backed bonds (e.g., Government 10-Year bonds), to compensate investors for higher risk of default.

Let’s step back for a minute and explain a confusing bond term: yield. Coupon yield is the amount a bond pays out in interest divided by the face value of the bond. Since bonds often trade on open markets, bond prices can fluctuate, so there’s another yield term: current yield. Current yield is the coupon payment divided by the current market price of the bond.

Current yield = Coupon payment / Market price

So, if the market price of a bond goes down because investors perceive more default risk, the current yield goes up. If there’s a bond with a $100 par value paying 5% per year, the payment is $5. If the market price is $95, the current yield would be $5/$95 = 5.26%.

One way to assess the overall high-yield bond market is to look at the yield spread – the difference between government bond current yield and corporate bond current yield. At 1743 basis points (17.43%) at March 5, 2009 the spread indicates that investors have very low tolerance for extra risk – a situation that reflects the amount of bad economic news. Mackenzie’s portfolio manager on Mackenzie Sentinel Corporate Bond Fund, Dan Bastasic, believes that this spread is overstating the severity of the risk, therefore creating a value opportunity in corporate bonds.

By comparison, in May 2007 the spread was 2.50%, the tightest it had ever been. At that time, access to money was easy and investors perceived little risk in high-yield bonds. Then the subprime issue hit, credit seized up, and by December 31, 2008 the spread had grown to 1724 bps. As of early March, with a spread of 17.43 %, high-yield investors are being well rewarded for assuming the higher default risk.

Slow economic growth is good for corporate high-yield bonds. According to Bastasic, the future for the sector looks bright. He states that high-yield bonds have substantially outperformed equities during the three-year period coming out of the past three recessions.

And Bastasic believes that spreads will come down as efforts by governments around the world to stimulate economic growth kick in. But he believes the recovery will happen slowly.