Julius Baer: Significant upside potential for high yield bonds

Both of these parameters are way outside of any historical precedent, including the Great Depression of the 1930s. Even within the context of still broadly negative corporate news flow, these pricing levels appear both excessive and unsustainable.

For investors willing and able to take a more strategic view, the asset class offers significant upside for 2009 with further material upside into 2010. At the same time, a running yield of 18.5 per cent provides considerable downside protection.

We believe that several factors will eventually jump-start this market even if corporate news flow remains challenging for some time to come: central banks and governments around the world have been increasing liquidity and attempting to kick-start credit; time will bring data points, both macro and micro, that will enable investors to gauge future risks more easily and at some point, the flight-to-quality, flight-to-liquidity and de-leveraging trade that has been so damaging will end.

With markets set to remain challenging, selection will be absolutely key to investment success. We are likely to witness an unprecedented degree of returns dispersion among sectors and individual issues. Some bonds currently trading in the twenties may end the year in the eighties and vice versa, although it is important to remember that most bonds trading at distressed levels are doing so for good reasons.

We also believe that there will be surprises in terms of what sectors do well and poorly this year. For instance, healthcare is currently a popular choice with investors, while most cyclical sectors are treated as if they were radioactive. Certain sectors and companies undoubtedly have better prospects than others in this environment, but there will inevitably be cases of over- and under-discounting. The rewards and penalties for picking the right and wrong investments are likely to be similar to those normally seen in equities.

In this environment, we intend to focus on relative value and avoid being distracted by rumour, market sentiment, or short-term technicals. We believe the best areas are in bonds issued by solid companies but associated with troubled or beaten down sectors, or debt being trading in markets where liquidity has virtually dried up, namely EUR-denominated or selective emerging markets corporate paper.

Besides minimising credit costs, restructurings on the back of the current default cycle should also provide compelling opportunities.

Ralph Gasser is product specialist, fixed income for Julius Baer. The view expressed here is his own