High yield bonds have been one of the most popular fixed-income investments in the past couple of years as the Federal Reserve’s three rounds of quantitative easing have pushed benchmark interest rates to rock bottom. The Fed has been indirectly supporting the high yield market by pushing yields lower across the yield curve.
A reversal in trend has come about after the Fed decided to slow down its massive bond-buying program by $10 billion each month. This is leading to a recovery in the benchmark interest rates, making Treasuries and floating rate notes more attractive.
The year 2013 proved to be outstanding for high yield bonds. The stage was set for high yield bonds in the four-year period from 2009 to 2012 in which high yields delivered double-digit returns three times and outpaced the investment-grade market in each calendar year. With the Treasury yields at an all-time low, there seems to be more of a downside risk than upside potential left.
There was also a huge rise in leveraged loan issuance, as corporations took advantage of the low interest rates to refinance their existing obligations and lock in a low cost of debt. Nearly 70% of loans earmarked for refinancing or repricing in 2013. With most of refinancing covered in the previous year and improving economic conditions, leveraged loan issuance backing mergers and acquisitions are expected to increase in the coming year.
With the expected rise in interest rates, high yield bond issuance may witness some slowdown as rising Treasury yields would immediately repel risk-averse investors in view of declining relative value and increasing default risk on the bonds. Since most high yield bond issuing companies have already taken advantage of lower interest rates to refinance their debt on more favorable terms or postponed maturity, the potential for rising defaults in these companies has been reduced. Leveraged loans, paying floating rates, will continue to gain investor interest as they offer higher yields than Treasury.
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