Are High-Yield Bonds in a Bubble?

By Michael Brush  AUG 24, 2012 10:05 AM

The bubble crowd is going off the tracks by merely looking at yields in isolation.

 


MINYANVILLE ORIGINAL 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.
 
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%. 

 

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.

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.

Editor's Note: Michael Brush is the editor of the stock newsletter Brush Up on Stocks and a weekly market columnist for MSN Money.
No positions in stocks mentioned.

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