Finding Yield in Volatile, Low-Interest Rate Markets

Amid a fixed-income universe that includes low-yielding assets and high-risk sovereign eurozone issues, two burgeoning bond segments are drawing well-deserved attention — U.S. high-yield corporate bonds and emerging markets local-currency debt.

In the aftermath of the 2008-2009 credit crisis, and with the eurozone debt crisis continuing to unfold, institutional investors face a predominantly low-yielding environment throughout much of the bond universe. To help stimulate the U.S. economic recovery while other regions struggle to avoid a double-dip recession, the U.S. Federal Reserve Board has restated its pledge to maintain short-term interest rates at low levels through 2014.

Meanwhile, Italy, Spain and Portugal have had to offer unusually high yields in order to attract sufficient interest in their sovereign bonds from reluctant investors. A lack of compelling opportunities in those high-risk markets and other regions have led to much greater demand — and even lower yields — on safe-haven sovereign bonds issued by the United States, United Kingdom, Germany and Japan.

Against this backdrop, both U.S. high-yield corporate bonds and emerging markets debt offer attractive yields and risk characteristics that institutional investors should consider.

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U.S. High-Yield Bonds

At year-end 2011, the U.S. high-yield bond market, as represented by U.S. High Yield Master II Index, yielded 8.24%, a hefty premium over the 1.88% yield of the 10-year U.S. Treasury bond. But high-yield bonds offer more than just a yield premium.

“Given all the liquidity that has been injected into the financial system in recent years, high-yield issuers have been able to refinance their debt at attractive rates,” said Colin Robertson, managing director of fixed income at Northern Trust. “As the economy looks healthier and with the Fed's intention to keep interest rates low through 2014, many companies have stronger balance sheets and will feel less funding pressures. With non-risk-based assets yielding nothing, high-yield bonds are in a sweet spot — but no one can foresee exactly how long interest rates can stay low.”

If interest rates rise because of economic growth, Robertson explained, high-yield bond issuers should continue to perform well, with greater profitability and low default rates.

In this environment, Robertson favors holding at least a market weighting in U.S. high-yield corporate bonds, up to a 50% or even 100% overweighting. Should a shock occur to the financial system, causing fear to rise along with interest rates and possibly leading to inflationary pressures, Robertson said investors would want to reconsider the weighting of U.S. high-yield bonds.

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Emerging Markets Debt

Emerging markets countries have followed a path parallel to many U.S. high-yield corporate issuers. In recent years, emerging markets countries have strengthened their balance sheets and learned from previous financial crises while benefiting from high rates of economic growth.

Although ongoing risks associated with investing in bonds issued by, or within, emerging markets countries continue to persist, investors are compensated for that higher risk with a compelling yield. As of March 31, the JP Morgan GBI-EM Global Diversified Index yielded 6.41%.

In recent years, emerging markets countries have strengthened their balance sheets and learned from previous financial crises while benefiting from high rates of economic growth.

“Right now, you could actually make a pretty strong case that there is less risk in emerging markets debt than in European sovereign debt,” said Chris Vella, chief investment officer of multi-manager investments at Northern Trust.

“While there will always be a risk premium assigned to emerging markets debt, a lot of these economies have great growth opportunities and they have survived crises and come out of them with an improved fiscal position,” Vella said. “They have learned from their past and are moving in the right direction, consistently migrating toward investment-grade status.” In fact, the average rating of emerging markets local-currency debt issues is BBB+ as represented by the JP Morgan GBI-EM Global Diversified Index.

Vella also noted the difference between local-currency bonds and hard-currency bonds (denominated in U.S. dollars, yen or the euro). “Local-currency debt can offer diversification benefits for investors whose fixed-income allocations are primarily in U.S. dollar-denominated markets by providing a more complete ‘delinkage' from U.S. monetary policy,” Vella said.

“Overall, for investors looking to diversify their U.S. dollar exposure, increase their risk profile slightly and stretch for a bit more yield, emerging markets bonds make a lot of sense,” he added.

As Robertson and Vella point out, adding U.S. high-yield bonds and emerging markets local-currency bonds to a well-diversified portfolio is not without its risks. But in a persistently low-yield environment, income-seeking investors searching for higher yield may find these strategies offer compelling compensation.

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