November 2012

US HIGH YIELD DEBT: High-quality junk is not an oxymoron

JunkyardThe US high yield corporate debt market has been one of the few successful asset classes in the crisis era. Nicholas Pratt asks if it has staying power. There are few places in today’s market where investors can expect flat, single high-digit returns and a coupon that has returned an average of 8% per annum over the past 25 years, but the US high yield corporate debt market is one. Accommodative fiscal policies have helped. The Federal Reserve has brought short-term interest rates down to zero on government bonds, effectively forcing participants in the short-term money market to take on more risk. Second, the default rate, the biggest driver of volatility in the high yield market, has remained low (around 2%) for the past few years. Corporates have been able to do a lot of refinancing, reducing coupon debt from 11% to 7% and extending the maturity of their issues (more than half the market now matures beyond six years), all of which has reduced refinancing risk substantially. There is also the fact that other fixed income instruments are not providing the same kind of returns. “Investment grade bonds yield around 3% in the US and emerging market bonds are returning lower than the historical average but it is still possible to get a 6 to 7% return in US high yield bonds, so money has been pouring into the market, especially in the past two years,” says Jeff Peskind, a portfolio manager with US-based credit hedge fund Phoenix Investment Adviser that specialises in distressed US corporate debt. Meanwhile, equities are producing similar returns but with much greater volatility, meaning that many institutional investors are using US high yield bonds as an equity surrogate. There has also been a change in the investor profile, post-crisis. The disappearance of leveraged hedge funds that were also active in the credit default swaps and cash bonds markets has provided a lot more stability, says Russ Covode, managing director and portfolio manager, high yield bonds at US-based asset manager Neuberger Berman. These hedge funds have been replaced, to an extent, by non-US institutional investors who are realising that so-called junk bonds are not as junky as they first thought. “They’ve become far more comfortable with US high yield debt,” he adds. US institutional investors have been comfortable with high yield debt for a long time because of the attractive risk/return profile but also the low correlation with other asset classes. “High yield is a unique beast, largely because of the coupon which provides a lot of downside protection in more volatile markets. It’s a good asset class to add to your portfolio in terms of diversity,” says Covode. But as successful as the US high yield debt market has been, there is a perception that a peak has been reached. In the week ending October 3, high yield bond funds tracked by EPFR Global posted outflows for only the sixth time in 2012. “Some fund managers are arguing that the value has been squeezed out of junk bonds,” it says. The high yield market is trading at an all-time high in dollar terms and the yields are at an all-time low, so the result will be more of a coupon clip, says Todd Youngberg, global investment director at Aviva Investors and head of high yield investments. “Consequently, some investors may see a limited upside – 6 to 7% – and the equity surrogate argument may not work for those who are optimistic about equities,” he says. “But similarly, the 6 to 7% yield with low volatility may suit those investors who are less optimistic about equities.” In addition, with both default rates and interest rates likely to remain low, pricing may well be less attractive, especially when the high yield market is broken down into different tiers or credit-ratings quality, says Doug Forsyth, portfolio manager of Allianz Global Investors’ US high yield fund. “Many BBs are yielding less than 5% against coupons that are above 5%, reducing the flat level return. So it is unlikely that we will be able to reproduce the same level of returns that we have seen in the past 12 months. “We don’t believe there is a lot of price appreciation available given how expensive BB high yield bonds have become. The best total return opportunity is in the single B space where companies yield more than BBs and have better price appreciation.” Alternative managers like Phoenix see the best opportunities in the CCC space which they view as a niche of inefficiency in the capital markets. The default rate is low, and there is good liquidity, so the only question is whether the investors can handle that type of volatility.” Yet other managers, especially those that see themselves as long-term investors, would argue that historically the CCCs have produced a higher yield but lower total return because investors are not being paid for the heightened default risk. “The average annual default rate for CCCs has been 23% over the past 25 years and the last three default cycles compared with 1% for BBs and 5% for Bs,” says Youngberg. Mismatches
“High-yield investing is all about managing the downside. It is very asymmetric and there is much more downside than upside with individual bonds. The upside is the coupon plus limited price appreciation, but the downside could be your recovery rate after a default. “So, while you want the flexibility to be able to invest in CCCs, you have to be sensitive to the default risk.” One thing many managers are agreed on, though, is the inappropriate influence that published credit ratings have on the high yield market, given that there are CCCs that should not be treated as such and BBs that could be low single As. “Unfortunately, published credit ratings may not match current company fundamental statistics,” says Forsyth. “There are mutual funds, structured products and pension fund mandates that prohibit the use of CCCs. So, like it or not, we all have to understand what the published ratings are, but that does present an opportunity for investors to take advantage of these mismatches.” And despite the changing attitude of many institutional investors towards high yield bonds, Forsyth believes there are still investors that wrongly see non-investment grade bonds as more volatile than they really are and are, therefore, leaving money on the table. “The high yield market is worth $1.4 trillion in the US. It is heavily invested in around the world and we know that there is less volatility than in the equities market. But many people still approach the high yield market as though it is more volatile and I don’t believe that attitude has changed.” Managers are reacting to this by offering less volatile alternatives to their flagship high yield funds. Neuberger Berman has a short-term duration high yield fund that is geared towards the more defensive investors that are prepared to give up some yield in return for lower volatility. Such strategies are especially suitable for European insurance companies facing Solvency II that have higher reserving requirements for longer duration instruments. Phoenix has recently launched its Institutional Credit Fund and Aviva is increasingly providing customised mandates in credit quality tiers and short-term duration strategies for non-US institutional investors, something that Youngberg sees as a fundamental development in the high yield market. Ultimately, managers would prefer to see institutional mandates that allow them much more room to customise. And as the high yield market continues to produce positive returns with little volatility but with value perhaps harder to find amid its growing popularity, investors may well be inclined to allow fund managers more flexibility to explore related strategies and asset classes. According to Youngberg, Aviva Investors has recently received a mandate from a European insurance client that includes global high yield bonds and bank loans, and the flexibility to go anywhere in the debt capital structure. Institutional-focused managers will be hoping such a mandate is indicative of a changing attitude and realisation that high-quality junk is an investable asset class and not an oxymoron. ©2012 funds europe

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