High-yield bonds may pay off for investors

The recent dramatic gyrations in financial markets have driven home to investors the importance of protecting their portfolios from the pain of extreme volatility.

One strategy that can help is to invest in assets that provide a steady income stream, such as dividend-paying stocks as well as bonds.

Such investments are especially crucial for older investors who have retired or are nearing retirement. But they can also be a valuable part of any portfolio, as they add to an investor's total returns and help smooth out the investment ride over the years.

In particular, high-yield bonds may be of interest to investors seeking better returns amid low interest rates, according to money managers.

"High-yield bonds offer investors the opportunity to benefit from higher income in a low-interest rate world," said Mr Ben Tai, head of distribution at Allianz Global Investors in Singapore.

"The US high-yield market is the largest in the world and offers investors attractive risk-adjusted investment opportunities in today's environment of low growth, low yields and high volatility," he added.

"Adding yield to portfolios helps to add stability, boosts total return and can provide an extra income stream, which is particularly important in today's volatile market."

US high-yield bonds make up about 80 per cent of the high-yield bond market and have a total value of about 21/2 times that of Singapore's stock market, according to Allianz Global Investors.

One measure of the market's performance shows that between 1988 and last year, high-yield bonds have delivered only five years of negative returns, going by the BofA Merrill Lynch US High Yield Master II Index.

High-yield bonds typically pay higher interest rates than bonds issued by investment-grade companies or governments, because they have a higher risk of defaulting on their payments to investors.

But the default rate of high-yield bonds has been falling recently and is currently near historic lows.

The default rate over the 12-month period ending May was 1 per cent, compared to the long-term average rate of 3 per cent to 4 per cent, said Mr Tai.

This is because credit fundamentals of high-yield bond issuers remain in a "very healthy state", with solid balance sheets and near-record cash levels, he added.

In addition, high-yield issuers have been reducing debt levels and are better able to meet their interest payments.

"Currently, strategists do not see (default rates) increasing above 2 per cent this year or next," Mr Tai said.

Despite the turmoil over the last month on fears of the United States Federal Reserve exiting its stimulus plan, equity and bond prices are still expected to be supported either by a better economy or by continued easing, added Mr Tai.

"Nothing has occurred over the last month or weeks that would have any bearing on default rate expectations," he said.

Even when interest rates do rise, high-yield bonds can offer diversification benefits for bond investors.

This is because they have a low correlation with investment grade bonds and a negative correlation with US Treasuries.

The fundamentals of US high-yield bonds remain favourable, according to Mr Vasu Menon, OCBC Bank's vice-president of wealth management for Singapore.

Mr Menon is "cautiously optimistic" on the asset class as he expects risk appetite to remain healthy amid the gradually improving global economy, which should give a boost to high-yield bonds.

"We are (also) positive on the outlook for the US dollar, which favours US high-yields," Mr Menon added.

The strengthening US economic recovery is also likely to attract greater investment demand into US assets, while keeping default rates low for US high-yield issuers, he said.

Meanwhile, global growth is expected to stay slow this year, said Mr Douglas Forsyth, managing director and portfolio manager for Allianz US High Yield Fund.

This has the double effect of ensuring that high-yield issuers remain conservative in taking on debt, while prompting central banks around the world to continue flooding markets with liquidity.

"Forecasts of economic statistics point to a slow-growth environment for 2013. This will lead corporate executives to continue to position for conservative balance sheet strategies," he said.

Meanwhile, the US Fed has been joined by global monetary leaders in an accommodative stance, pursuing quantitative easing policies at an unprecedented rate.

"All of these factors combine to create an environment where defaults are low, and should stay low, for at least the next 24 months," Mr Forsyth added.

For investors keen on adding high-yield bonds to their portfolio, they can either buy the bonds directly or invest in funds such as Allianz US High Yield or Allianz Income and Growth, which offer a diversified exposure to these assets.

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