Outlook for High Yield Bonds Poor in 2007

High yield bonds have generated great returns over the last twelve months gaining over 11%. Just like 2004, the lowest-quality segment of the bond market, has performed the best in 2006. Over the same time period, the S&P 500 gained about 17%, and the Lehman Aggregate Bond Index gained approximately 4.5%.

Bonds with a low credit rating are called high yield bonds or junk bonds. A low credit rating reflects the borrower’s ability to pay interest and principal could be impaired. High yield bonds pay their lenders (owners of the bond) a higher interest rate to compensate them for the increased risk of default.

Junk bonds have risk and return characteristics comparable to a mix of stocks and bonds. In other words, the volatility (price movement up and down) and gains (returns) generated by high yield bonds are more analogous to equities (stocks) than bonds. When compared to stocks, high-yield bonds appear pricey especially when you compare yields. Junk bond yields are close to all-time lows when compared to the earnings yields on both the S&P 500 and Russell 1000 indexes.

It is the wrong part of the market cycle to be purchasing high yield bonds. Most economists expect the economy to slow in 2007. Junk bonds perform best as the economy climbs out of a recession and credit-quality improves. Inversely, junk bonds tend to perform poorly at the end of an economic boom. If the economy falters, companies with less creditworthy debt tend to default on their interest and/or principle payments, hurting the high-yield asset class both directly (through reduced interest payments) and indirectly (a loss of confidence, resulting in a higher risk premium and lower prices).

As of last week, high yield bonds yielded just 308 basis points (100 basis points is 1%) above the 10-year Treasury. From a peak in late 2002, this is a dramatic decline. Back then spreads were over 900 basis points. The current level is well below the historical average, suggesting that high yield bonds are overvalued. Please note, yield differentials typically reach 300 basis points during periods of healthy economic growth, so current spreads are not outrageous given our current level of economic growth. However, the high yield bond market is priced for perfection and if the economy slows high yield bonds will probably perform poorly. It is not a good time to be investing in high yield bonds. On a risk return basis, it would be better to be invested in the S&P 500.

Libby Mihalka