While the absolute level of high yield bond returns will most assuredly be more modest in 2013, returns relative to other asset classes may still look strong, and there should be more opportunities for the active investor to add value by selecting the right credits and the right industries to invest in.

More so than any time in the past three years, there will be a growing dispersion of returns across issuers within the high yield universe and it will matter what an investor doesn’t own as much as what is owned in the portfolio.

This will be an environment where merely having index-like exposures won’t be the best approach, as some of the largest issuers are debt-laden credits that may materially underperform in a slow growth environment.

Focus on risk
When we consider the risks to our constructive view on potential high yield returns in 2013, we need to evaluate where possible surprises might arise as the year progresses. Investors will need to keep an eye on valuations to ensure that we continue to be amply compensated for risks incurred. Key risks for the high yield market are default risk, interest rate risk, event risk, and changes in the risk premium. We believe that the first three risks will remain sufficiently benign so as to not be key drivers of overall high yield.

The global high yield index provides a spread versus duration-matched US treasuries of just over +500 basis points, which remains well wider than the tights of +225 bps experienced in the spring of 2007, and should be more than ample to cover losses due to defaults. Both interest rate risk and event risk are greater potential threats for investment grade credit than for high yield. So, as has been the case over the past two years, material changes in high yield bond spreads will most likely be driven by changes in the risk premium in the coming year as investor risk appetites shift in response to economic data or official policy action.

Such periods of volatility can create buying opportunities for investors who are not yet at their target exposure and who seek incremental yield in their portfolio. The overall market environment in 2013 will be one that should remain hospitable for high yield bonds; there may be the occasional short-term correction but a protracted bear market is unlikely. The credit cycle is now approaching its fifth year since recovering from the 2008-09 default wave; high yield credit fundamentals remain solid, and lingering macro risks have kept management teams cautious with respect to balance sheet and liquidity management. 2013 may be another year that global high yield, like corporate bonds in general, remain in the sweet spot.

• Even after a solid rally in global high yield in 2012, valuations continue to be supported by credit fundamentals.
• The yield premium available over government bonds remains attractive, particularly with the default rate expected to remain well below the long-term average in 2013.
• Extremely accommodative monetary policy provides a supportive backdrop for continued credit spread tightening in 2013.