Shifting Away From Junk Bonds

TheStreet.com

NEW YORK ( TheStreet ) -- Worried about rising interest rates and volatile stock markets, investors have been selling high-yield bonds -- which are rated below-investment grade. During the past month, high-yield funds dropped 2.0%, according to Morningstar. Is it time to move away from the low-quality issues? Some top managers think so.

Speaking at the Morningstar Investment Conference in Chicago last week, some managers warned that high-yield bonds are still rich. The managers have been selling their expensive holdings and shifting to such unloved fare as European bonds.

Since the financial crisis, high-yield bonds have ranked as one of the top-performing fixed-income assets. During the past three years, high-yield funds returned 10.2% annually, compared to 4.3% for the Barclays Capital U.S. Aggregate bond index. The funds scored gains as they rebounded from heavy losses that occurred in 2008.

In the worst days of the credit crisis, many high-yield bonds yielded more than 10%. Then as investors regained confidence, they began bidding up bond prices. When bond prices rise, yields fall. By early May this year, yields on high-yields bonds had reached record lows of less than 5%. Since then, yields have climbed back to 6%. "That is still a pretty low overall yield," said Tad Rivelle, portfolio manager of TCW Total Return Bond .

Instead of high-yield bonds, Rivelle favors bank loans. Those are loans made to below-investment grade companies. While the loans only yield about 5%, they are more secure than high-yield bonds. Loans are considered senior to high-yield bonds. So in the event of a default, owners of loans are paid first, while investors in high-yield bonds must wait in line and hope to receive whatever assets are left.

Besides holding securities that are rated below-investment grade, TCW Total Return also owns stakes in mortgages and other high-quality instruments. Portfolio manager Tad Rivelle varies the mix. During the past five years, the fund returned 9.6% annually, compared to 5.5% for the Barclays Capital U.S. Aggregate.

In recent years, Rivelle has scored big gains with non-agency mortgages. Because they are not backed by the government, the non-agency mortgages must yield more than the common mortgages that are backed by Fannie Mae and other agencies. During the financial crisis, non-agency securities plummeted as investors worried about defaults. Since then, the securities have rebounded, but they still offer relatively rich yields of around 5.5%.

Rivelle said that the securities remain undervalued and should continue rallying.

"With the non-agency mortgages, you have the potential to get high single-digit returns and possibly double-digit returns," Rivelle said.

Another manager who has shied away from high-yield issues is Steve Smith, portfolio manager of Legg Mason BW Global Opportunities Bond . After markets began recovering from the financial crisis, Smith held a big stake in corporate bonds, including high-yield issues. But lately he has shifted almost entirely away from corporate issues. A global manager who is free to invest anywhere in the world, Smith has been shopping in troubled countries of Southern Europe.

"We have been selling expensive corporate issues and buying Portuguese bonds that were yielding 9.5%," he said.

The shift to Portugal might seem like an unlikely move, but Smith has made a career of going against the crowd. His fund currently has 4% of assets in Malaysia and 3% in Hungary. The portfolio has only small holdings in developed countries such as Japan and Germany.

The contrarian moves have often paid dividends. During the past five years, the fund returned 7.9% annually, topping its average peers in the world bond category by almost 3 percentage points. Smith argues that the Portuguese issues represent good values. The securities are rated BB, one step below investment grade.

Curtis Mewbourne, portfolio manager of PIMCO Diversified Income , ranges around the globe, holding a mix of U.S. and foreign bonds. Lately he has been shedding high-yield bonds and shifting to securities from the emerging markets. Holdings include bonds from Russia and South Africa. The wide-ranging approach has enabled the fund to return 8.5% annually during the past five years, outdoing 76% of multi-sector bond competitors.

Mewbourne particularly likes Brazilian bonds. While the country has an inflation rate of 6.5%, the bonds yield 11%.

"Brazilian yields have increased substantially in the last six weeks, and the country has sound credit fundamentals," he said.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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