Keep Your Eye on the Ball
High Yield Bonds Give Investors Something to Swing At


April 2012

For three decades, investing in top-rated bonds and income-producing stocks was like hitting a batting practice fastball, waist high and right down the middle of the plate.

With inflation soaring in the early 1980s, cash briefly paid 20%,1 Treasury bonds yielded almost 16%,2 and dividends from U.S. stocks hit 6%.3

Crack!

Since then, falling inflation and slowing growth has allowed rates, yields and dividends to drift lower, lower and lower still.

Most of those last 30 years were a Golden Era for bond investors: attractive yields combined with falling short-term interest rates to generate total returns that were competitive with stocks, yet with less volatility.

Nice. Very nice.

Playing it safe
Then came the Great Recession and its perilous aftermath.

Serious liquidity and solvency issues in Europe, lackluster economic growth in developed countries, and extraordinary loose monetary policies everywhere pushed yields on Treasuries and investment-grade bonds to historic lows.

By last fall, 10-year Treasuries yielded just 1.7%;4 more recently, yields on investment-grade corporates fell to a record low of 3.27%.5

Despite rebounding in March, benchmark Treasury yields are still a percentage point under the inflation rate. Investment-grade corporates are only slightly more generous, providing just a one percentage point margin over inflation.

In effect, government and investment-grade corporate bonds functioned as a lifeboat in economic seas made unusually turbulent by concerns about a double-dip recession in the United States, a breakup of the eurozone and an economic hard-landing in China.

“There was a lot to worry about,” says Colin Robertson, head of fixed-income investing at Northern Trust. “There still is, but the global macroeconomic environment has improved in recent months.”

Getting offensive
That improvement bolsters the case for shifting some money from government and investment-grade bonds into lower-rated corporate debt, where attractive nominal and inflation-adjusted yields still can be found.

Though Robertson likes the investment-grade sector as well, he sees high yield as especially fertile territory.

And with good reason. By keeping policy rates at virtually zero, “the Federal Reserve is pushing investors into more risky asset classes,” Robertson says. “And what the Fed wants, the Fed usually gets.”

Despite a rally this year that nudged prices higher — and yields lower — speculative grade bonds yielded around 7% as of March.6

“That’s about five percentage points higher than core inflation,” notes Robertson. “You won’t find real yields like that in too many other places.”

Naturally, some investors are concerned that interest rates might soar if economic growth caught fire. But Robertson says that worries over tighter money are premature and misplaced.

A called third strike?
Despite a better tone to the labor market in recent months, Robertson is skeptical that the recovery will prove strong enough or inflation troublesome enough to compel the Fed to tighten sooner than expected. He thinks a third round of central bank money-printing, known as quantitative easing, is likely if the economy decelerates again later this year.

“A QE3 would be very favorable for high yield bonds,” he says.

Of course, gasoline prices are cause for concern. But policymakers usually consider energy-based inflation to be transitory, and thus an insufficient reason to change course.

More important to the Fed, according to Robertson, are the unemployment rate and non-farm payrolls, the U.S. housing market, domestic and global economic growth data, core inflation and inflation expectations. “In that order,” he says, “which means we’re probably years away from rate hikes.”

The return of a not-too-hot, not-too-cold economy could be especially favorable for high yield bonds. Robertson says economic growth of around 2% would be the “sweet spot” for the high yield sector, since it would be fast enough to boost corporate earnings yet slow enough to keep the Fed on hold.

Indirectly, the innovative easing policies of the European Central Bank (ECB) under its new president, Mario Draghi, also have driven storm clouds from the high yield market. The ECB extended cheap three-year loans to hundreds of eurozone banks, helping financial institutions clear short-term liquidity hurdles.

“The threat of a liquidity crisis in Europe was the main tail risk hanging over the high yield market,” says Robertson. “Even if the probabilities of a Lehman-style event were low, they were still high enough to give some investors pause.”

Then there’s the Fed’s pledge to keep interest rates near zero until at least late 2014. Promises can be broken, but that seems unlikely given the labors that the Fed has undertaken to keep the recovery trudging along.

As long as rates are anchored near zero, bond yields could be on a short leash.

“They probably can’t stray too far,” notes Robertson, “even if economic growth surprises to the upside.”

Staying cautious
Still, zero short-term interest rates are an ideal time for companies to issue debt and refinance their operations. What would happen to high yield bond prices if companies suddenly gorged themselves on cheap credit?

As it turns out, not necessarily what you might expect.

Historically, the yield differential between Treasuries and high yield bonds has narrowed as loan demand perked up.7 That’s because rising loan volume signals an improving economy, and thus is favorable for lower-rated credits.

The shaky aftermath of the financial crisis actually might have worked to the benefit of the domestic high yield sector, according to Richard Inzunza, manager of the Northern High Yield Fixed Income Fund. Below-trend growth and festering concerns about the long-term viability of the eurozone has kept U.S. businesses on the straight-and-narrow, thus limiting their appetite for risk.

Less risk-taking could translate into fewer defaults down the road.

“Usually by this time in a normal credit cycle companies would be getting more aggressive with their finances,” Inzunza says. “They’d be doing acquisitions, leveraged buyouts and boosting dividends. This time they’ve stayed conservative, which is why the default rate has remained low despite the absence of a typical V-shaped recovery.”

Indeed, corporate bond defaults have surprised on the low side since the recession ended. During the last year, the default rate on U.S. speculative grade bonds was just 2.33%,8 well below the long-term average of nearly 4.46%.9

Although some analysts expect defaults to increase in 2012, Inzunza doesn’t project that number to move much above 3%, at worst.

“Coming out of the last recession, companies cut costs, reduced leverage and used the ultra-low interest rate environment to rollover debt on much more favorable terms,” Inzunza says. “Combined with strong balance sheets and the cautious operating mentality that’s still in place at most businesses, which means that high yield is in good shape from a credit standpoint.”

Adds Robertson, “The high yield market appears to be very healthy.”

Room to run
The sector also appears attractively priced, if no longer a raging bargain.

The spread between yields on speculative grade bonds and Treasuries has dropped from a peak of almost 2000 basis points (20 percentage points) during the financial crisis to less than 600 basis points, as measured by the Barclays Capital U.S. Corporate High Yield 2% Issuer Cap Index in early April.10

That’s still above the long-term average, according to Inzunza, and hints at further spread tightening on the horizon. Spreads reached an all-time low of 243 basis points in 2007.11

“High yield has rallied, but there is room for further price appreciation,” says Robertson. “I could see spreads tightening to 400 basis points.”

Even if spreads widened, it wouldn’t necessarily undermine long-term performance. In four of the five major incidents of spread widening since 1987, it took less than a year for the extra income generated by high yield securities to offset the price declines. The exception was the 2007–’09 recession, when it took 27 months to reach the break-even point.12

While the price of government and investment-grade bonds could slip in a quickening recovery, the opposite might be true for high yield securities.

“High yield is an economically sensitive sector,” Inzunza says. “If you believe, as we do, that the economy will at least muddle along, sub-investment grade credits could join in some of the rally that stocks would be likely to enjoy.”

Indeed, high yield debt often trades more in synch with equities than with top-rated bonds. “But usually with less volatility than stocks,” Inzunza says.

Batter up!
There also are opportunities for growth-oriented investors to boost their yield without taking undue risk.

So-called income-equity funds hold a portfolio of dividend-paying stocks and bonds that are convertible into stocks. The latter asset class, known as convertible bonds, often carries a higher yield than the underlying shares.

Though yields on convertibles have shrunk, along with those from the overall investment universe, many remain well above that of the average U.S. stock.

And that is where they are likely to stay, since many companies prefer share buybacks to dividend hikes as a means to return cash to shareholders.

“Given economic uncertainty, some management teams are reluctant to make the commitment that raising the dividend suggests,” notes Jackie Benson, portfolio manager of the Northern Income Equity Fund. “Having to reduce a dividend has serious negative connotations.”

Benson also warns against taking a simplistic approach that values a high dividend above all else.

“Current yield is an important component of total return, but it is not an end in itself,” she says. “A high dividend yield can be a red flag.”

Rather than pile into the highest-yielding stocks or convertibles just to “check the box,” Benson uses a conservative strategy that seeks to uncover low-valuation securities that could be expected to perform well over the long haul.

And that’s important because, like a long extra-inning baseball game, it often takes time for the best team to win.

Hitting to all fields
Investors looking for attractive yields in a low-yield environment might want to consider the Northern High Yield Fixed Income Fund and the Northern Income Equity Fund. The Northern High Yield Fixed Income Fund is designed to provide core exposure to the domestic high yield fixed-income market while capitalizing on Northern Trust's strong credit culture. Potential Replacement Value provides a profile of the Northern High Yield Fixed Income. Through its combination of income-producing stocks and convertible bonds, the Northern Income Equity Fund seeks to generate equity-like returns, but with less volatility than an all-stock portfolio.

Talk to your Northern Trust relationship manager for more information about how these two Northern Funds offerings could help you reach your financial objectives.

Bond Risk: Bond funds will tend to experience smaller fluctuations in value than stock funds. However, investors in any bond fund should anticipate fluctuations in price, especially for longer-term issues and in environments of rising interest rates.

Equity Risk: Equity securities (stocks) are more volatile and carry more risk than other forms of investments, including investments in high-grade fixed income securities. The net asset value per share of this Fund will fluctuate as the value of the securities in the portfolio changes.

High Yield Risk: Although a high yield fund's yield may be higher than that of fixed income funds that purchase higher rated securities, the potentially higher yield is a function of the greater risk that a high yield fund's share price will decline.

Interest Rate Risk: Increases in prevailing interest rates will cause fixed income securities, including convertible securities, held by the Fund to decline in value.

1 Federal Reserve
2 Financial Times. March 2, 2012
3 Standard & Poor’s, Robert Shiller
4 Financial Times. March 2, 2012
5 Financial Times. March 8, 2012
6 The New York Times. March 22, 2012
7 Barclays Capital, Federal Reserve
8 Standard & Poor’s
9 Standard & Poor’s
10 Moody’s Capital Markets Research Group; Barclays Capital
11 The Wall Street Journal. February 27, 2012
12 Northern Trust Global Investments, Barclays Capital

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