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Fixed-Income Insights

High-yield bonds and convertibles compare favorably with stocks over the long run.

The improvement of growth in the United States, which prompted the Federal Reserve to taper its monthly bond purchases, will likely support both lower-quality bonds and convertibles in 2014. This is good news for investors who are concerned about the effect of rising interest rates on the bond market, but who may still be somewhat wary of stocks.

As Chart 1 shows, over rolling 10-year periods between January 1, 1988, and March 31, 2014, convertibles and high-yield bonds have outperformed investment-grade bonds 93% of the time.

 

Chart 1. High-yield Bonds or Convertibles Have Outperformed Investment-Grade Bonds 93% of the Time
Outperformance Over Rolling 10-year periods, January 1, 1988– March 31, 2014


Source: Morningstar.
Investment-grade bonds (intermediate-term) are represented by the Barclays U.S. Aggregate Bond Index. High-yield corporate bonds are represented by the Barclays U.S. High Yield Index. Convertibles bonds are represented by the BofA Merrill Lynch All Convertibles All Qualities Index. Past performance is not a reliable indicator or a guarantee of future results. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific Lord Abbett mutual fund, or any particular investment, and are not intended to predict or depict future results.  Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. High-yield securities carry increased risks of price volatility, illiquidity, and the possibility of loss in the timely payment of interest and principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.Convertible securities have both equity and fixed-income risk characteristics. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

As Chart 2 shows, high-yield bonds and convertibles historically have generated returns that are comparable to those of the stock market. The risks, as measured by standard deviation, however, are notably less.

 

Chart 2. High-Yield and Convertible Bonds Have Compared Favorably with Stocks on Risk and Return
Average annual returns and standard deviations, January 1, 1988–April 30, 2014

Source: Morningstar.
Return is represented by the average annual return.  Risk is represented by standard deviation.
High-yield corporate bonds are represented by the Barclays U.S. High Yield Index. Convertible bonds are represented by the BofA Merrill Lynch All Convertibles All Qualities Index. Equities are represented by the S&P 500 Index. Past performance is not a reliable indicator or a guarantee of future results. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific Lord Abbett mutual fund, or any particular investment, and are not intended to predict or depict future results.  Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. High-yield securities carry increased risks of price volatility, illiquidity, and the possibility of loss in the timely payment of interest and principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities. Convertible securities have both equity and fixed-income risk characteristics. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies, including market, liquidity, currency, and political risks. The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, fixed-income prices fall, and when interest rates fall, fixed-income prices generally rise.

 

Investors may be concerned about the prospects of rising interest rates and their effect on these alternatives. The Fed's return to a less accommodative monetary policy seems certain to push interest rates higher, especially on those securities that it will no longer purchase, namely agency mortgage-backed securities and longer-dated Treasuries. In 2013, the mere anticipation of tapering pushed longer-term U.S. Treasury yields higher and, subsequently, produced negative returns among traditional high-quality bond havens.

As for the impact of higher interest rates on high-yield bonds, in a previous Market View, we examined why the spread between the yield on high-yield bonds and that on U.S. Treasuries is below the long-term average, and why it may stay that way for some time. We noted that spreads typically rise in anticipation of increasing defaults and that indications are that default rates will remain low through the end of 2015.

Why are default rates likely to stay low? Companies have refinanced their borrowings at lower interest rates. This means decreased interest costs for the company, as the payments it has to make on its debt are smaller. The relief from higher interest costs also could free up cash for capital spending to boost revenue growth. More important, it could make these companies better able to withstand economic downturns.

An additional effect of the refinancing push is that the maturity dates on much of the debt have been extended into the future.  With more time until their debt is due, and lower interest expense in the interim, high-yield issuers are much better positioned to meet their debt obligations. Therefore, default rates should remain low.

As a result of all the factors we’ve listed here, yield spreads on high-yield bonds relative to Treasuries could remain below average for a continued period of time, and supply and demand factors could create a continued positive environment for high yield. This could give investors the opportunity for attractive income, with the additional prospect of total return.

“While lower-quality bonds, because of their economic sensitivity, should perform relatively well as the Fed tapers, convertibles offer perhaps an even more interesting alternative,” said Zane Brown, Lord Abbett Partner and Fixed Income Strategist. “Convertibles may provide relatively attractive income, while enabling participation in rising equity markets. And, historically, they have provided some downside protection during periods of declining stock prices.” [There is no guarantee, however, that they will continue to do so in the future.]

If Fed tapering is dependent on better economic growth, that growth could enhance corporate earnings and promote respectable equity returns. Bonds that are convertible into equities tend to participate in that equity movement, depending upon the proximity of the price of the underlying stock to the strike price of the convertible.

When equity prices decline, so will those of related convertible issues, though probably not as significantly as one may think. At some point, the bond characteristics of the convertible kick in, and the price stops falling when the convertible becomes attractive as a pure bond. Indeed, the traditional return profile of convertible securities indicates that while they might capture approximately 70% of an upswing in the underlying equities, they might participate in only about 40% of a decline in the underlying equities.

This could mean that investors who would like to increase equity holdings, but are fearful of a market decline, might consider convertible bonds as a less volatile strategy to gain equity exposure. Other equity investors who want to protect their downside risk, yet are fearful of missing out on additional upside moves in the market, also may select convertible bonds as a less volatile substitute for current equity holdings. 

 

RELATED RESOURCES


  Market View
  U.S. Market Monitor

RELATED FUND
The Fund seeks to deliver high current income and long-term growth of capital by investing primarily in a variety of fixed income securities and select equity-related securities.
RELATED FUND
The Fund seeks to deliver current income and the opportunity for capital appreciation by investing primarily in high yield corporate bonds.
RELATED FUND
The Fund seeks to deliver current income and the opportunity for capital appreciation by investing primarily in convertible securities.

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