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Portfolio > Mutual Funds > Bond Funds

Making the Case for High-Yield Bonds Before the Fed Rate Hike

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Despite expectations that the Fed will be raising rates by year-end or soon after, some strategists are bullish on U.S. bonds, especially high-yield bonds that provide investors additional income.

Larry Adam, chief investment officer and chief investment strategist at Deutsche Asset & Wealth Management, says that high-yield spreads in the past four rate rising cycles continued to narrow going into the Fed’s first rate hike and after. The reason: companies are able to pay the interest and repay principal of their debt because the economy is improving, which is why the Fed is raising rates in the first place. Narrower spreads indicate that high-yield bonds are appreciating in value relative to other bonds.

Adam told a webinar sponsored by Deutsche X-trackers this week that during 12 different periods since 1989 when interest rates rose 1% or more, high-yield and emerging market bonds outperformed because their higher yields more than offset any capital depreciation.

But he warned that investors now have to take more than five times the risk they would have taken in 1987, 1990, 1995 and 2000 to collect roughly 6% because now they have to move into high yield to collect that level of income.

Adam noted that long-term Treasuries, which he does not favor now, are essentially considered high yield by much of the rest of the world since the 10-year Treasury yield now is 160 basis points (1.6%) higher than the 10-year German government bund.

Richard Bernstein, CEO and chief investment offer of Richard Bernstein Advisors, who also presented at the webinar, says he favors high-yield munis outside of Puerto Rico bonds.

“This is an area in the fixed income market that has been shunned by a lot of fixed income investors,” said Bernstein, noting the proof of that is the wide yield spread between munis and other bond markets. The muni high-yield composite spread to Iraq bonds is 20 points, for example, said Bernstein. “I’m not quite sure what the right risk premium is for ISIS, but I bet this chart is not reflecting that … There should be a big discount here, not a big premium.”

An even more dramatic example from Bernstein: a 200-basis-point (2%) spread between the muni high-yield composite and Lebanese bonds. “You’re buying Hezbollah. That seems nutty to me,” said Bernstein.

Bernstein emphasized that he’s “not advocating that anybody invest in Puerto Rico but we think there are some interesting things to be found in that [high-yield muni] market if you’re looking for yield.”

In Puerto Rico Wednesday, the Puerto Rico Electric Power Authority (PREPA) reached a deal with creditors to make a $416 million payment and avoid default for the time being. The commonwealth is still roughly $70 billion in debt that its governor says it cannot pay without the ability to reduce and restructure its debt.

— Check out Puerto Rico Bonds May Be Hiding in Your Clients’ Portfolios on ThinkAdvisor.


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