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Betting On High Yield Bonds To Beat Equities In 2012

When you invest in risk, you want the reward, right? Yet, emerging market and high yield bonds in general have underperformed safety all year. The trend, says David Sherman, manager of the RiverPark Short Term High Yield (RPHYX) bond fund could be drawing to a close.

“Although the high yield market sentiment often is correlated to the equity market, the space has gotten very beaten up. Unless Europe and the U.S. address their balance sheets and provide world leadership to rebuild confidence, I suspect high yield will outperform equities over the next 12 months,” Sherman says.

“Investors can earn a yield-to-maturity on an average duration of around 3 years in high yield in excess of 12% on a diversified portfolio rated B/B- with Debt/EBITDA of under 4.5 times,” he says.

The Merrill Lynch High Yield Master II Bond Index ended the third quarter down 1.69%, the fourth worst quarterly performance since September 1986.

The risk trade had investors pouring into Treasury bonds. Outflows of high yield bonds and ETF funds totaled $10.4 billion in August and September, roughly 0.34% of the market’s actual size, according to Lipper.

As a result of the sell-off in the quarter, Sherman thinks high yield is now undervalued given the current low interest rate environment. Plus, a weak outlook in the U.S. and Europe, coupled with slower growth in China, means the global economy will likely “muddle through” the next 12 months, making high yield bonds a defensive investment class with equity like upside, Sherman says. In a worst case scenario, such as a double dip recession, high yield would get clobbered.

High yield bond spreads soared in 2008 by more than 400% to more than 700 basis points over Treasurys before declining in 2009. Bond spreads are always higher on riskier debt because bond holders are being compensated through yield for future losses that may be incurred in a debt default. Cohanzick believes that high yield spreads are currently priced to produce 170% greater after-tax yields versus 10 year TSYs after adjusting for future default losses and taxes. Last month, average interest rates on high yielding corporate debt stood at 8.84% compared to 1.9% for 10 year TSYs.

“I dont like Treasurys, but that doesn’t mean U.S. government bond prices will continue to retreat,” he says. Ten year bond prices have fallen below par after trading well into the 120s for all of September.

“It is hard to fight the Fed and herd behavior. We had a pretty significant short on 10 year Treasurys, which we ultimately threw in the towel. I shorted the Treasury yield thinking lack of political leadership from Washington, the U.S. debt ceiling, and the general continued deterioration of the U.S. balance sheet would demand a higher real interest rate by lenders. I was surprised that after S&P downgrade, the UST rallied,” he said.


Bank of America bonds.

While an advocate of high yield corporate debt, Sherman warns investors away from Bank of America bonds yielding over 5%. “I wouldn’t touch them just from a fundamental risk versus reward perspective,” he says. “Bank of America takes credit, trading, and operating risk every day and employs significant leverage. Any tiny mistake is magnified. I don’t like the idea of being at the bottom of the capital structure since depositors are senior to me in which I make limited upside but the downside is horrible. Maybe an interesting stock investment because you enjoy the spoils of success with similar downside risks as bondholders. But as a bondholder with a capped upside on a financial institution business model, ‘no thank you’.”