Investors Benefit from the High-Yield Bond Boom

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The U.S. high-yield bond market has been buoyant in 2012, recording unprecedented corporate issuance and strong investor fund flows, while also turning in strong performance. This may underscore the value in holding high-yield corporate bonds as part of a diversified investment portfolio.

From 1993-2011, a period which incorporates numerous market cycles, the benchmark Bank of America Merrill Lynch High-Yield Master II index generated annual returns of 8.34%. The strong performance so far this year marks something of a recovery – high-yield bonds returned 4.38% last year. This underperformance, relative to the average long-term return of high-yield bonds, reflected investors reducing risk following the downgrade of U.S. debt, as well as prolonged uncertainty about the U.S. economy and the stability of the eurozone.

Another factor driving investor interest in high-yield bond funds has been the very low yields in another popular asset class – investment-grade corporate bonds. Those yields, which fell to a record low in February (according to a Barclays’ index that tracks data back to 1973), have led investors to look at alternatives offering higher yields, and there has clearly been some migration to the high-yield sector. The Federal Reserve’s declaration that short-term interest rates will remain low for the next few years is having a similar effect.

Booming issuance

There has also been a surge in issuance of high-yield bonds this year. In the first quarter of 2012, low-rated companies issued $75 billion of such bonds – higher than any other quarter since Thomson Reuters started collecting such data in 1980. While corporations use the proceeds for a variety of purposes, most popular is refinancing existing debt. The refinancing, which reduces the likelihood of corporate bankruptcies, helps to mitigate risk in the marketplace.

Investing in high-yield bonds

For investors, high-yield bonds can serve many different purposes. In addition to offering strong, risk-adjusted returns, they also promote diversification, given their very low level of correlation with mortgage-backed securities, Three-Month Treasuries and Ten-Year Treasuries. High-yield bonds have a higher (but still modest) correlation with investment-grade corporate bonds, large-cap stocks and small-cap stocks.

Nevertheless there are a few guidelines to keep in mind. First, investors should invest with a longer term investment horizon and focus on multi-year performance when looking at high-yield mutual funds, as yields are poor predictors of performance. Over shorter periods, high-yield bonds can be quite volatile. In 2008, for example, the Bank of America Merrill Lynch index declined more than 26%, and then rose 57.5% the following year.

Second, following the strong performance of the high-yield bond market in the first quarter of 2012 with prices rising above par, future positive returns are likely to be less price-driven and more a function of the income earned going forward. Third, high-yield bonds are best owned as part of a fund, not individually. A diversified collection of such bonds is critically important (given the risk of a corporate default), but difficult for individual investors to achieve. Similarly, fund managers can access more robust research and more efficient price execution than individual investors.

Finally, corporate defaults pose the biggest risk to the strength of the high-yield bond market. But with U.S. corporations in a strong financial position, the outlook for defaults continues to look benign – further underscoring the wisdom of investing in the high-yield market.

You should consider the investment objectives, risks, charges and expenses carefully before investing. Please call (877) 518-9161, or go to www.tiaa-cref.org for a current prospectus that contains this and other information. Please read the prospectus carefully before investing.

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