U.S. high yield bonds rep­re­sent an oppor­tu­nity for investors to ben­e­fit from a resur­gence in the "risk on" trade, while get­ting some down­side pro­tec­tion against the cur­rent eco­nomic soft­ness, says BCA Research, this week.

Rel­a­tive to equi­ties, junk bonds are expen­sive, how­ever it is rep­re­sen­ta­tive of a last­ing trend of raised equity risk pre­mium that BCA says is not likely to fade away any­time soon. In absolute terms, cor­po­rate bond val­u­a­tions remain attrac­tive, as well as in rela­tion to Trea­surys, in the con­text of min­i­mal default risk, and con­sid­er­ing the recent backup in spreads.

The health of cor­po­rate bal­ance sheets is also sus­tain­ing improve­ment, and the Fed's low inter­est rate envi­ron­ment has investors seek­ing yield for the fore­see­able future, and could most likely result in yield spreads being pushed well into over­bought ter­ri­tory, before this rally comes to an end.

Junk bonds have per­formed superbly since the begin­ning of the rally in March 2009, and BCA believes the favourable con­di­tions enabling junk bond investors to profit still have some way to go.

The inverse rela­tion­ship between junk spreads and Trea­sury yields is one of the impor­tant rea­sons high yield has out­per­formed dur­ing the most recent "risk off" period. That is, the Trea­sury curve shifted lower while spreads widened, and this had off­set effects on on junk yield levels.

Should the oppo­site con­di­tions occur, in the event the econ­omy has a stronger sec­ond half, Trea­sury yields should increase, how­ever, spreads should nar­row even more, accord­ing to BCA.

Given the uncer­tain eco­nomic out­look, this makes the junk bond index's run­ning yield attrac­tive; BCA's bot­tom line call — Upgrade high-yield back to overweight.

Source: BCA Research — Daily Insights

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