(October 9, 2012) — The high-yield bond market may have reached its peek, according to Hozef Arif, senior vice president and portfolio manager of Pacific Investment Management (PIMCO).
High-yield bonds returned 12% through September, even as corporate defaults continued to rise, albeit gradually, he writes. Thus, some investors asking whether greater caution may be needed looking ahead.
Arif concluded: “While we expect this trend to continue in 2012-2013, we also note that actual default events generally are a lagging indicator when it comes to spread and return performance of the high-yield market. More important, we think, is how high-yield returns will likely continue to be sensitive to equity markets – even more so now than what long-term history would suggest.”
Arif continued to note that while market optimists point to current low default rates and forecasts, skeptics warn of potential increases in defaults leading to lower returns as a reason to reduce their exposure to high-yield. “It is those exceptions, or ‘surprise defaults’ across an industry or a sector, that have the most potential to negatively affect the market,” the author asserts. “One example is the 2001 to 2002 default cycle, when three different default surges came in quick succession: the telecom bubble bursting after WorldCom went bankrupt, the bankruptcies in the utility sector and the accounting scandals.”
In addition, the paper concludes that high-yield valuations and returns tend to be strongly tied to equities–a correlation that has become even more pronounced since the recent recession.
Thus, according to Arif, investors would be wise to closely monitor equity markets for signals on where high-yield spreads may go.