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Andrew R. Jessop, Hozef Arif
The global high yield market delivered a notably strong performance in 2012, with total returns of 15.6% in the U.S. and 27.1% in Europe, according to BofA Merrill Lynch’s U.S. High Yield and Euro High Yield Indexes. Within the index holdings, a budding housing market recovery translated into the highest gains for the financial, real estate and building materials sectors in the U.S., with total returns exceeding 25%. In Europe, the financial sector was the best performer with a 46% total return, following policy-induced market stabilization in late 2011 and then again, during the summer of 2012. Given the broad-based nature of the 2012 rally, yields and spreads are now in a narrower band than they were at the beginning of 2012 and 2009 (see Figure 1). In addition, most high yield bonds have call options that enable the issuers to retire the bonds before maturity (i.e., negative convexity), limiting their upside potential. With an average price of $105.13 as of 31 January 2013, almost 82% of U.S. high yield bonds that have call options (72% of the total high yield market) are currently “trading to call date” – using the call date as the assumed maturity date − which is very near the historical high, as illustrated by Figure 2.
Taken together, tighter spreads, narrower yield dispersion, increasingly limited upside and the potential for future re-leveraging activity warrant additional caution when approaching the high yield asset class. Still, from a strategic perspective, given its income-generating potential (due to its relatively high current coupon compared with other credit spread products), overall lower volatility compared with equities (in both U.S. and global indexes) and limited near-term default outlook, we think high yield should continue to be part of a diversified asset allocation.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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