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Executive Summary

• The underlying fundamentals for corporate and high yield bonds remain in place as we move into 2013, but the economy and the “fiscal cliff” are important variables.
• Yields are low on an absolute basis, but within historical norms relative to U.S. Treasuries.
• While corporates and high yield can continue to produce solid performance, investors need to temper their expectations for 2013.

Excellent 2012 Performance Results

Investment grade corporate and high yield bonds delivered excellent performance in 2012. as the ultra-low rates on safer assets caused investors to gravitate to the more attractive income available in these areas. Both asset classes were also boosted by the improvement in the financial health of the underlying issuers, as seen in the rising earnings and strengthening balance sheets of U.S. corporations. The question now, of course, is whether all of these trends can remain in place in 2013.

The Positive Underpinnings Are Still There, But…

The case for continued strength in corporates and high yield bonds (the “credit sectors”) typically cites three main factors:

1) With the Federal Reserve maintaining its low-rate policy, investors will have no choice but to continue buying the credit sectors in order to find respectable yields.

2) The U.S. economy, while sluggish, is nonetheless strong enough for corporations to remain in robust health, which should continue to support performance for corporates and high yield.

3) Default rates – or the percentage of companies that fail to make scheduled interest and/or principal payments – remain near historical lows, which continues to provide a positive backdrop for the market.

These three factors indeed should help limit the downside in the credit sectors in 2013. However, yields are also very low on a historical basis – indicating that there isn’t much value in these sectors as there was one or two years ago. In addition, low yields raise the likelihood that an adverse development – such as a news event or a recession – could cause meaningful price declines for corporate and high yield bonds. (Keep in mind, prices and yields move in opposite directions .) In this sense, the potential upside for these sectors is relatively limited, while the downside is much larger.

Investors therefore need to be careful buying in at these levels — as do those who have poured money in during the past two years, and who have therefore experienced only positive markets. This is especially true for high yield. One outgrowth of the frantic demand for high yield bonds is that more companies have been able to issue debt, including those with shaky credit. Citigroup reports that $293 billion in high yield bonds had been issued year-to-date through November 30, Companies recognizing an opportunity to take on debt at low rates issued a record $293 billion in junk bonds through November. In comparison, the prior full-year record was $271 billion, reached in 2010.

The result: the overall risk of the sector is rising, even as yields are plumbing all-time lows. High yield therefore isn’t offering as much value as it was in 2011 or even in early 2012.

How Low are Yields, Really?

Yields are a moving target, of course, but at the end of November the largest corporate bond exchange-traded fund. iShares iBoxx $ InvesTop Investment Grade Corp. Bond Fund (ticker:LQD) offered a 30-day SEC annualized yield of 2.75%, while the largest high yield ETF, iShares iBoxx $ High Yield Corporate Bond Fund (HYG) yielded 5.76%. Both are still well above the 1.61% yield available on the 10-year U.S. Treasury note on that date. However, both are also near the low end of the historical range. Indeed, high yield bonds spent much of the second half of the year trading at both all-time low yields and all-time high average prices. This was a source of caution for many investors during the second half of 2012, but both corporate and high yield bonds continued to rise nonetheless.

One reason for this was that yield spreads – or the yield advantage of the spread sectors relative to U.S. Treasuries – remained reasonable. According to the Federal Reserve Bank of St. Louis, investment grade corporate bonds averaged a yield advantage of 1.67 percentage points over U.S. Treasuries from 1997 through 2012. At the end of November, that spread was in line with the historical average at 1.61. High yield bonds, meanwhile, averaged a yield advantage of 6.01 percentage points over U.S. Treasuries in the same period, compared with 5.58 at the end of November.

Interest Rate Risk vs. Credit Risk

Although this article considers corporates and high yield together for the purposes of the 2013 outlook, the two asset classes respond in different ways to changes in the investment environment. Investment grade corporates are more sensitive to changing interest rates, whereas high yield bonds are more sensitive to credit risk. or in other words, the health of the underlying issuers (and by extension, the economy).

This is where the 2013 outlook for corporate bonds and high yield diverges. If the economy slips into a recession in 2013, interest rates would fall. In this scenario, corporate bonds would likely provide flat returns (with an advantage for this highest-quality issuers) while high-yield bonds would be hit hard. Conversely, a sudden revival in growth would be a positive for high yield, but the resulting rise in Treasury rates would be more of a negative for investment grade issues. Both scenarios are less likely than the middle ground – in which the economy continues to muddle through with growth in the 1-2% range – but investors need to be aware of all of the possibilities.

The Bottom Line

It’s only natural that investors would be somewhat leery of asset classes that have performed as well as corporate and high yield bonds in the past three years. During that time, the two asset classes produced average annual total returns of 9.30% and 12.30%, respectively, based on index performance through November 30. With such high returns already in the rear-view mirror, it’s highly unlikely that corporates and high yield can continue to deliver similarly robust performance in 2013. In addition, week-to-week volatility is likely to rise – a contrast from the relatively steady upward trend that characterized 2012. Still, the yield advantage of these two areas continues to provide investors with a very favorable starting point relative to either Treasuries or cash equivalents.

More on What to Expect in 2013 :

Disclaimer. The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.