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* High-yield bond funds seen slowing after stellar 2012
* Yield-hungry investors drove up demand
* Default rates are very low, but new issuers flood in
By Andrea Hopkins
TORONTO, March 4 (Reuters) - After three years of fantastic returns and a particularly stellar 2012, Canadian asset managers predict a return to earth for high-yield bond investments as surging demand and recovering stock markets take the shine off junk bonds.
While no one is saying the party is over - solid single-digit returns will still far outstrip returns on government or investment-grade debt - wealth managers say it is time to start reducing the expectations of junk bond buyers.
"We had a great year last year, our life was wonderful and the sun was shining every day," said Lorne Steinberg, president of Montreal-based Lorne Steinberg Wealth Management, whose Steinberg High Yield Fund notched a 13.7 percent return in 2012.
"This year we are cautioning clients that the lovely double-digit return in 2012 is not going to be repeated in 2013 ... we're looking to be in that mid-single digit, that 6 percent area this year."
Bonds of the riskiest U.S. companies have delivered a total return of 143 percent since bottoming in December 2008. A widely followed measure of the sector, the Bank of America/Merrill Lynch High Yield Master II Index, hit a record high in January and sits just a smidgen below that record.
With yields on safer assets such as government debt near historic lows, bond managers and investors have flocked to high-yield bonds, also called junk bonds because they sport below-investment-grade ratings by Standard & Poor's and Moody's.
"Since the financial crisis, as more investors have flooded into fixed income, this spread differential has come in and we have seen yields on both investment-grade and high-yield bonds decrease," said Ilias Lagopoulos, fixed income portfolio strategist at RBC Wealth Management.
RBC's Global High Yield Bond Fund notched one-year return of 11.7 percent and a three-year return of 10.2 percent, but the latest one-month return was negative 0.2 percent.
Lagopoulos doesn't think the good times are totally finished, in part because interest rates aren't expected to rise any time soon, ensuring a solid spread differential remains between investment grade and high-yield debt. In addition, default rates - the principal risk of junk bonds - have fallen to near historic lows because cheap money has strengthened corporate balance sheets.
Junk bond issuers are typically technology or, in Canada, resource companies that haven't made any money yet, or, more typically in the United States, investment-grade companies that have fallen on tough times.
While the default risk may have eased for junk bond issuers, Steinberg said the new risk is that the demand for high-yield debt is drawing new creditors into the market who may offer less protection to investors.
"What happens it is there is so much demand it becomes indiscriminate demand, and issuers get away with looser covenants - the protections don't have to be as great," he said.
Typically, a junk bond issuer has to agree to certain conditions in a covenant, such as not selling any assets before paying off bondholders. But each issue has its own covenant and with high demand, such protections are getting looser, Steinberg said.
"For us, we spend our time on research, we simply avoid those issues, but a lot of those issues get done because there is just so much demand. So buyer beware."
There are two major ways for Canadian investors to get in on the high-yield game: actively managed funds composed of a few dozen bonds hand-picked by the fund manager, or exchange-traded or index funds, which sidestep the expense of active management by choosing a big, diversified pool of 200 or more bonds.
The majority of Canadian high-yield bond funds are comprised of U.S. and Canadian debt issues, with the U.S. market greatly overshadowing Canada's small junk bond market.
"Your main risk is individual security risk, the default risk," said Rob Bechard, head of ETF portfolio management at BMO Asset Management in Toronto.
"So either you're going to pick a good manager that can pick good companies that aren't likely to default, or if you are picking an index product, look for one that doesn't have a lot of concentrated risk, an ETF that has a lot of names in it, over 200," he said.
Bechard said BMO's High Yield U.S. Corporate Bond ETF, comprised of some 250 individual bonds, notched a return of 14.6 percent in 2012. But now he believes a "wait and see" approach may be the way to go as investors watch for the U.S. economy to pick up or tank again as the budget crisis unfolds.
"Any investor who is looking to add (high-yield bond exposure) to their portfolio has to be aware that it has had a pretty good run," Bechard said.
RBC's Lagopoulos said a good strategy for yield-hungry bond managers is to look for short duration credit, which will allow them to be nimble and jump to better issues if rates rise or jump to equities - most bond funds allow for some equity exposure - as needed.
Steinberg said these days he'd rather have a 1.5-year bond yielding 6 percent than a 10-year bond yielding 8 percent - just to avoid the risk of rising interest rates because a bond that is close to maturity won't react as much to rising rates.
"We have never been concerned with being the highest-yielding high-yield fund in Canada. We've always been concerned with having the safest high-yield fund in Canada that still delivers a good return for our clients," Steinberg said.
"Because if you are going to shoot for the top returns, you are going to at times take the excessive risk."