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Thomas Kenny

The Rally in High Yield Bonds is Unstoppable... for Now

By January 24, 2013

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For months, market-watchers have been warning about the unsustainability of the rally in high-yield bonds. High yield has put up four straight years of strong performance coming out of the financial crisis: 28%-plus in 2009, 14.4% in 2010, 5.4% in 2011, and 14.7% last year. And so far in 2013, the asset class is already up another 1.4%.

While this has been a phenomenal development for anyone already in the asset class, the future potential upside in high yield is growing more limited with each passing day. This week, Barron's Michael Aniero reported that the yield on the average high yield bond is now just 5.63%, an all-time low, while the average price of a below investment-grade bond is at a record high of $105.77 (versus a par value of $100). Nothing has changed fundamentally - the default rate (or the percentage of companies that miss interest or principal payments) is low, high yield issuers remain in healthy financial condition as a group, and the Federal Reserve's policy of ultra-low interest rates continues to push investors into riskier investments.

At these levels, however, the high average price begins to limit appreciation potential. Further, investors may begin to question whether high yield bonds are worth the risks with yields in the mid-5% range. And not least, the lower yield takes a bite out of future total returns. Since 1996, the average yield for the asset class has been 9.9%. Now, with yields at 5.6%, that's 4.4 percentage points of historical return that investors won't be seeing in 2013.

The bottom line? The trade-off of risk and return in high yield bonds is becoming less favorable the longer this rally goes on. Tread carefully.

Learn more:

2013 Outlook: Corporate and High Yield Bonds

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