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By Timothy Strauts

With record fund inflows in 2012, investors clearly have an appetite for high-yield bond funds. The strong investor demand lowered credit spreads, and the high-yield category returned over 14% last year. While yields have been falling, high yield is the only bond category with a 12-month yield still above 5%. After four consecutive years of positive returns, is now the time to allocate money to high yield, or is the sector fully valued and ripe for a fall?

Market Expectations
Fitch Ratings and JPMorgan are currently projecting a high-yield default rate of 2% or lower, below the long-term average default rate of 4.8%. These predictions are based on United States gross domestic product growing at 2%, the European debt situation stabilizing, and the U.S. debt ceiling issue being resolved by Congress. With the average high-yield bond trading above par and below-average credit spreads, there is not much capital appreciation available, so returns will come predominantly from the coupon. The consensus seems to be projecting returns for 2013 of between 6% and 8% for the sector.

Risks to Consensus
Historically, high-yield bonds have been one of the riskiest fixed-income sectors. In 2008, the high-yield bond category had a drawdown of over 32%. Since 1989 there have been 12 occurrences of drawdowns of over 5%. High yield is what's known as a high-kurtosis asset class, which means that extreme market events happen more frequently than in other asset classes. As you can see from the chart below, high yield is prone to negative shocks.

(click to enlarge)

The primary benchmark for the sector is the BofA Merrill Lynch High Yield Master II Index, which has a current credit spread of 5.0%, below the long-term average of 6.0%. The credit spread is the difference in yield between the index and similar-duration U.S. Treasury bonds. While the credit spread isn't extremely low yet, when you look at yields on an absolute basis the picture looks much worse. The current yield of the index is only 6.1%--the lowest yield ever recorded. The yield has fallen a long way since it last peaked in December 2008 at over 23%.

One of the aims of the Federal Reserve interest rate policy is to increase risk-taking across the capital markets. High yield is one of the main beneficiaries of the Fed's current policy. With yields of investment-grade securities below 3%, investors have been forced to look elsewhere for income. Many institutional investors that in the past only chose investment-grade bonds have been buying high yield to meet their return targets. This new demand has pushed yields down and given corporations the ability to refinance a lot of debt in 2012. It was a record year with over $300 billion in new bond issuance. The ability for even very low-rated, highly leveraged companies to get financing has helped many firms stay afloat when they would otherwise have defaulted in a normal year. The high demand for these speculative issues has caused some investors to discard fundamentals in favor of searching for the highest yield without regard for quality. This strategy has worked so far, but at some point demand will soften, poor business fundamentals will catch up with firms, or the Fed will change its policy.

Another issue facing investors is that bond covenants are being watered down. Bond covenants are the rules borrowers and lenders agree upon at time of bond issue. Key covenants can limit how much debt a company is allowed to take or restrict a company from paying out a dividend that might hurt bondholders. As an investor, you want strong bond covenants. According to Moody's, covenant quality has steadily decreased over the last six months as issuers have used strong investor demand to push for more-advantageous terms for themselves. Covenant quality decreased substantially in the 2007 market and was an indication of a market top. While covenants are not as bad now as in 2007, it's never a good trend to see investor protections eroded.

When looking at fundamental factors, the high-yield market does not seem to be pricing in the risks facing the global economy. The European debt problems have not gone away. Europe is still trying to solve a debt problem with more debt with a longer maturity. The "fiscal cliff" crisis may have passed, but we now have debt ceiling negotiations to deal with. Large spending cuts favored by Republicans could push the economy into a recession. China seems to have stabilized after slower GDP growth last year, but it has debt issues of its own. Finally, heightened tensions between Israel and Iran could cause oil prices to spike if the dispute escalates further. If any of these situations worsens, risk-taking by investors could wane and cut demand to the high-yield sector.

In the last four years, high-yield bonds have experienced a total return of over 105%. With current yields at historic lows, decreasing bond covenants, and the continued economic risks, high yield doesn't look terribly attractive. I wouldn't want to bet against the Fed by shorting high yield, but an investment at these levels offers below-average returns with above-average risks.

ETF Options if You're Still Interested
The two biggest ETFs are iShares iBoxx $ High Yield Corporate Bond (HYG) and SPDR Barclays High Yield Bond (JNK). They've both received tremendous inflows in the last year and have over $12 billion in total assets. Since these ETFs need to maintain liquidity in their portfolio, they don't own as many low-rated issues as the broad high-yield index. This may help them if credit quality worsens, but it does mean that they offer lower current yields. Both ETFs have a current SEC yield of about 5.2%, 0.9% lower than the broad high-yield index.

If you're interested in an option with lower interest-rate risk, consider PIMCO 0-5 Year High Yield Corporate Bond (HYS), which has an average maturity of only 2.9 years. Unfortunately, lower maturity means lower yield because HYS only has a current SEC yield of 3.6%.

A final option for investors is an ETF that avoids the lowest-quality segment of the high-yield market. PowerShares Fundamental High Yield Corporate Bond (PHB) owns no bonds rated below B. Higher-quality bonds mean a lower SEC yield of 3.3%. In the current environment, I'd normally recommend PHB as the best option, but the fund has had trouble tracking its index. It has an expense ratio of 0.50% but trailed its index by 1.7% last year.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Is High Yield Overvalued?