Look to the U.S. for higher yields

Most of the action in the high-yield bond space is in the U.S., and the market’s becoming attractive for income-oriented investors.

“If you look at corporate earnings over the last several years they’ve generally been growing, though 2015 has seen a bit of a slowdown,” says Eric Takaha, director of Corporate and High Yield, Franklin Templeton Fixed-Income Group, in San Mateo, California. “If you look at liquidity, or how much cash companies have available to pay their bills, that’s also generally in good shape.”

Default rates, he adds, are fairly low—between 2% and 3% over the past year, which is about half the long-term average.

U.S. high yield has seen turbulence in energy and commodities, especially metals and mining. Combined, they make up about one-fifth of the U.S. high-yield market.

Takaha breaks down the valuation picture, which uses U.S. government Treasurys as a point of comparison. Overall, the average U.S. high-yield bond with an average maturity (seven years) will get you about 6.5% more than the average Treasury. The long-term average is about 6%.

However, default rates are currently a little over 2%, whereas the long-term average is just under 4%. “So, although spreads are a little cheap to the long-term average, the default rate for the last 12 months is still well below the long-term average.”

“Overall, valuations look pretty reasonable,” adds Takaha.

He likes the U.S. healthcare sector, where he’s had a considerable weighting for some time. “It’s almost the reverse of energy. It’s very defensive and tends to be non-cyclical.” While you won’t get the yields you’ll find in the energy sector, there are good returns to be had with relatively low risk.

Takaha says the high-yield investor’s key question always needs to be: Where in the market can you expect to see a significant rise in defaults? “[Apart] from energy and commodities, we just don’t see a lot of large companies that are likely to default over the next year,” thanks to their relatively stable fundamentals (earnings, cash flow, etc.).

Importantly, a default doesn’t always mean you lose your money, at least relative to current market prices, adds Takaha. Take a bond that was issued five years ago, but is now trading at a deep discount—40 cents on the dollar. A professional manager may conclude that bond actually represents an attractive investment to hold or buy, because even if the company defaults, bondholders may ultimately get, say, 50 cents on the dollar (a 10-cent profit on every dollar).

Note that the analysis that goes into these types of decisions is extremely complex and time-consuming, and should only be attempted by a professional bond fund manager. (Also read: Leave bond picking to the pros.)

Investment grade

Takaha likes the risk-adjusted return picture for investment-grade U.S. corporates. Again using Treasurys as a yardstick, the bonds on average are yielding about 1.7% more at present. At the beginning of 2015 it was 1.3%, and a year ago, 1%. So the trend is in the direction of better yields.

“In general, the fundamentals for investment grade [bonds] are solid and we don’t have a lot of concerns about significant downgrades,” he adds.

Outside North America

European high-yield overall has performed well over the last year relative to the U.S., partly because of Europe’s lower energy exposure. Since valuations aren’t as attractive as they were a couple years ago, Takaha has been paring back his exposure.

Emerging markets such Brazil, Mexico and Asian countries such as Malaysia have been hit pretty hard by the drop in energy prices. Weakness presents a potential buying opportunity, so Takaha is “looking at both sovereigns and corporates in those countries.”