NEW YORK: Six years of interest rate suppression by the US Federal Reserve has driven up prices for high-yielding assets and forced investors searching for income to overpay for everything from junk bonds to stocks that pay big dividends, top money managers told the Reuters Global Investment Outlook Summit this week.
“The high-yield market is sort of in a bubble and sooner or later there will be a price paid for that,” said Carl Icahn, the billionaire investor who said he owns credit default swaps on high yield debt against the five-year US Treasury note.
That means he is essentially shorting high yield debt while going long on the US five-year note.
“We think the risk-reward is great in that CDS,” he said.
The yield premium for owning junk bonds as opposed to far-safer US Treasuries, for instance, has shrunk from more than 9 percentage points three years ago to around 4.5 points now, according to Bank of America Merrill Lynch Fixed Income Index data.
Not only is that below the long-term average of about 5.9 points, it’s below what even some top junk bond mavens consider to be their fair-value spread over Treasuries.
Martin Fridson, chief investment officer of wealth management firm Lehmann Livian Fridson LLC and a long-time junk bond investor, would consider non-investment grade debt fairly valued at a spread of 5.65 percentage points.
“I don’t dispute that valuations are very rich,” Fridson said, calling investors ‘nervous.’
Default rates among junk issuers will likely rise in 2015 from the current 1.6 per cent, though it may take until 2016 for rates to return to the historic average of about four per cent, Fridson said.
Lower-quality corporate debt is ‘priced to perfection’ relative to anticipated default rates, agreed Chris Hentemann, chief investment officer of 400 Capital Management. “You have very little room for error.”
Fridson sees a strong probability that junk bonds will ‘underperform their coupon’ next year, meaning any positive return they deliver will be derived solely from their interest payments and that bond prices could fall a bit.
That’s been the case so far this year, as junk bonds have delivered a total return of about 4 per cent, with price declines of about 2 per cent being offset by a yield of about 6 per cent, according to Merrill Lynch’s High Yield Master Index.
The US Federal Reserve has kept interest rates near zero since December 2008, adding in US$3.7 trillion of bond purchases to help flood the market with cash.
While that’s helped push growth in the world’s biggest economy ahead of many other developed markets, investors have been left groping for returns.
Yields on the 10-year US Treasury note now hover around 2.3 per cent – still, higher than the 0.8 per cent on 10-year German government debt and the 0.5 per cent on 10-year Japanese government debt.
Greg Peters of Prudential doesn’t agree that investors are overpaying for yield across the board.
While he sees caution as warranted in the junk bond space, Treasury yields could go yet lower, particularly if, as he expects, the Fed sees little reason to raise rates next year and then moves slowly when it finally does.
“I haven’t seen much change fundamentally to suggest that yields are overvalued for fixed income,” said Peters, who helps manage over US$534 billion in assets as senior portfolio manager at Prudential Fixed Income, a unit of Prudential Investment.
Peters doesn’t see the yield on the 10-year Treasury yield rising any higher than 2.8 per cent in the next year and said it could go as low as 1.8 per cent.
The demand for yield in the current environment has spread outside of bonds.
In stocks, most of this year’s outperforming sectors sport dividend yields that are significantly superior to Treasury yields. The S&P 500 Utilities Sector Index, for instance, has a dividend yield of about 3.5 per cent and has delivered a total return of almost 24 per cent, double the return so far on the broader S&P 500.
Real estate investment trusts, or REITs, with a yield of 3.2 per cent, are up by a comparable margin.
Still, that means they’re no longer cheap. The price-to-earnings ratio for utilities, at nearly 20, is around the highest in at least a dozen years, while REITs are trading at 23 times cash flow compared with a long-time average of 16.
Of course, even these pricey assets can still attract buyers.
“People are just greedy,” said Cathy Roy, the chief investment officer for fixed income at Calvert Investments.
“The search for yield has just made people hold their nose and say, ‘I like the yield.’” — Reuters