Many Investors Don't recognise An Important Risk That Has Sprung Up In Their Bond Portfolios

We are just one month into 2013, and investors have already seen the relentless run in high-yield (HY) bonds continue. Despite a backup in the last week of January, HY has notched a total return of 1.39% so far this year, using the JPM US HY index data.

This has been a rally in terms of both spread and absolute price. HY spreads have contracted from 613 basis points in mid-November to 513 basis points on February 1. Loomis Sayles’s Dan Fuss, CFA, held little back in his recent comments to Barron’s: “High yield is as overbought as I have ever seen it,” Fuss said. “This is absolutely, from a valuation point, ridiculous.”

When a person like Fuss makes comments that strong, it’s worth digging a little deeper. Let’s look at two characteristics of the HY market that have changed over the past few years without many investors realising it.

Price appreciation has largely run its course

As we see from the chart, HY bonds are starting to exhibit negative convexity, with prices exceeding 105 cents on the dollar.

In other words, future price appreciation is capped because of the callability of the bonds. As Loomis Sayles’s Matt Eagan, CFA, said in an interview last month, HY bonds don’t typically trade at higher than par plus half their coupon. Well, guess what? We are at that place today.

Looking back at the previous few years of performance in the HY market is dangerous and unrealistic for investors attempting to project potential future returns. I  am not a financial writer giving you predictions but, rather, pointing out indisputable features of bond maths.


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