High Yield Bonds Are Able To Beat Inflation

High yield corporate bonds, my favourite bond class in 2010 and 2011, was the strongest performing fixed income sector in the first quarter of 2011. The sector surged over 3.9% year-to-date as at 31 March 2011 (in USD terms), outperforming the majority of the equity markets. Yields in the sector, as represented by the widely-tracked BofA Merrill Lynch High yield Master II index, have hit a record low level of 6.8% on 18 February 2011.This is lower than the previous record-low of 6.81% in december 2004. As a rule of thumb, the higher the price of the bond,the lower the resulting yields.Bond prices and its yields are inversely correlated with each other.

According to Lipper, as at 11 March 2011, the purchase of high yield bond funds amounted to US$32 billion in 2009, US$14 billion in 2010 and US$6.1 billion year-to-date. It was the 14th consecutive week of net inflows.The demand for high yield bonds has been robust since 2009 as investors want to take advantage of low interest rates to receive the attractive yields and potential capital gains. However, the category suffered a temporary setback with outflows in late March as some investors have started to take profits off the table. In a low interest rate environment, the investment value of high yield bonds is still attractive given that it offers higher yields compared with other bonds.

High yield bonds typically perform well during the period of economic expansion. The reason is that corporate earnings are boosted when the economy is on its upward momentum. the improvement in earnings and balance sheets would drive down the default rates and lead the rating agencies to upgrade the credit ratings. Yield spreads between high yield bonds and US treasuries narrow during periods of economic properity as investors require less compensation for the lower perceived default risk in the market.

The 2010 US economy GDP report highlights broad-based positives across both investment and consumption, with the latter showing significant strength. This provides strong support for the US corporate earnings in 2011. According to the market consensus, the overall earnings of US-listed companies will hit a new high in 2011.Thus, it is expected that default rates will continue to drop his year. The favourable economic and corporate conditions point to a benign credit environment which will continue to benefit high yield bonds.

In Singapore, inflation was 4.5% year-on-year in April, and few fixed income classes yield enough to beat this (the 20-year Singapore Govt Bond had a yield of just 2.82% as at 24 May 2011). High yield bonds are a notable exception and investors who want to beat inflation may wish to consider an investment in this highest-yielding segment of the market.