Credit: Yielding products, rising rates
Roy Kuo and Emily Upson run through the characteristics and recent performance of a range of yielding products, offering portfolio solutions for a rising rates environment
In this article we compare the traditional asset classes where interest or dividend income represents the main source of returns, focusing particularly on the factors behind the performance of liquid credit securities over the past 10 years and discussing how these credit securities may be affected by the macroeconomic environment going forward.
Figure 1 shows a corporate capital structure ordered by increasing risk. In a default situation, holders of the securities at the top of the capital structure will have the strongest claim over the company’s assets. Yielding asset classes can theoretically be arranged in a similar spectrum.
Equities should be at the bottom, having the least protection and the least predictable revenue streams but also the highest potential upside. We then move up to asset classes that provide steadier income but also have equity-type risks, such as mezzanine and convertibles, high yield debt, real estate and infrastructure investments. These offer the security of owning physical assets, but investors own the equity tranche of these assets and thus are subject to equity-type risks.
Further up come fixed rate senior corporate bonds with investment grade credit ratings. This is followed by loans and fixed rate government bonds, which could arguably be swapped because loans are not exposed to interest rate risk given their floating rate, but on this scale, because of the lower credit risk of government bonds, we put them slightly higher. Inflation-linked government bonds come last, because as well as having government bond credit ratings, they also give investors protection against inflation - although they are still susceptible to interest rate risk.
Performance of yielding assets over the past decade
We combine these asset classes to form one risk spectrum, which provides an indication of the expected amount of return (greater risk requires greater return) of the various asset classes. Figure 3 shows annualised total returns for each asset class over 10 years plotted against 10-year annualised volatility (as a proxy for risk). It gives some interesting results.
We would expect the asset classes to lie along a line from bottom left to top right, so that higher volatility should be matched by higher returns. Within the credit group, high yield bonds and fixed rate government bonds have broadly behaved how we expected, but convertibles, Treasury inflation-protected securities (TIPS) and loans have not.
One would expect convertibles to have had higher returns than high yield bonds given the fact that they often take on equity-like risks and can be wiped out at the same time equity is wiped out in a bankruptcy. Over the 10-year period which we are looking at, high yield bonds have had a higher number of better years than convertibles (namely 2001, 2003-05 and 2009-10), and they have been more volatile. However, one should view these returns in context. Many convertibles were issued by dot-com companies in the late 1990s using the lure of equity returns to obtain a lower cost of debt financing. This hurt the overall post dot-com performance of convertibles, but convertibles of companies with stronger business models performed better. In addition, convertibles outperformed high yield bonds throughout much of the past decade, with the exception of the past couple of years, when low interest rates led investors to seek the yield offered by high yield bonds.
Government bonds and TIPS have had broadly similar returns, but TIPS have lower volatility since they are less subject to changes in inflation and thus interest rate expectations (except in times of extreme inflationary or deflationary expectations such as the commodities inflation of 2007 and general deflation of 2008). TIPS seem to offer a higher total return for the risks associated with them. This could be due to falling interest rates which we have seen over the past 30 years. Older, higher-yielding off-the-run TIPS are tied to inflation rather than interest rates, so as rates fell investors seeking yield bought them and pushed up prices. In addition, the relatively new asset class benefited from increasing demand as investors became more familiar with it.
Traditional government bonds also benefited from this general fall in interest rates and have actually had a stronger run than TIPS since 2001, but their performance in the years prior to that was poor due to governments raising interest rates to slow down the dot-com bubble.
Loans have underperformed the rest of the credit spectrum in recent years thanks to two main factors. First, loans - traditionally the domain of banks - began to be securitised and syndicated in increasing amounts over the past 20 years, placing these securities in the hands of new investors unfamiliar with the assets’ characteristics. The banks and other holders, thinking that these loans were very secure assets, also began to use leverage and short-term financing to increase their returns. When short-term financing dried up during the financial crisis, many investors became forced sellers, causing prices to fall indiscriminately even though most loans were still performing.
The second factor is the general fall in interest rates to historic lows during 2008-10. The low LIBOR rates to which loans are linked have kept returns down, though many loans have LIBOR floors to prevent their coupons from becoming too small. The chart also shows how quickly and substantially LIBOR has increased in previous upturns in the economic cycle.
Investors have instead been looking to high yield bonds to provide yield in the current low interest rate environment. High yield prices fell the furthest of all bonds during the financial crisis (the Barclays Capital US High Yield index fell by 32% from its high in May 2008 to its low in November), but they have since rallied the most (up 95% from the low point). The average price of high yield bonds in December 2008 was 58 cents on the dollar (Credit Suisse High Yield Average Price index), and now they are trading above par. Also, default rates have dropped off faster than expected due to extraordinary measures by governments and central banks, such as quantitative easing, designed to stimulate their respective economies.
According to JP Morgan, high yield issuance in Q4 2010 reached a new record of $91.3bn (€63bn), showing that the high yield market is again accessible to a wide range of borrowers. That is pushing default rates down further, as lower quality borrowers have been able to refinance their debts. Out of total new issuance in the last quarter of 2010, 25.5% was rated B, CCC or non-rated, which is a large increase on the first three quarters of 2010.
Indeed, there was a sharp decline in the returns of many credit securities during the financial crisis and an equally significant recovery in prices since then. This was due to a mix of two main factors. Firstly, there was significant uncertainty in the economic environment after the collapse of Lehman Brothers, where either a deeper recession or potentially a depression would have occurred and caused a severe level of corporate defaults if governments and central banks had not stepped in. The introduction of extraordinary measures such as quantitative easing has restored confidence to the markets, and the recovering economy has reduced default rates.
Secondly, the use of short-term funding by many investors, especially the banks, to acquire many of these securities created a liquidity crisis and heightened counterparty risk when funding dried up; the investors could not hold on to their positions and became forced sellers. This severely depressed prices on the securities even if the underlying collateral was still performing. It is interesting to see that all of these securities are now above their high points achieved during 2007-08 and back to their trend lines for the decade. This shows that the underlying value of these securities has been maintained despite such a traumatic period in the markets.
What should credit investors be looking at now?
The recovering economy and monetary stimulus by the central banks have led to a rapid recovery in bond prices and a narrowing of spreads of riskier bonds over government bonds. However, credit spreads are still wider than they normally would be in the growth portion of an economic cycle. As economies continue to recover from the downturn, credit spreads should continue to narrow, providing managers who have a good understanding of lower quality credits to benefit from the improvement in the fundamentals of those businesses and a narrowing of the credit spreads on their corporate bonds.
This should benefit non-government credit securities, especially senior loans, high yield bonds and convertible bonds, since these securities are typically issued by firms with lower credit ratings.
We believe that the overwhelming factor which will impact the credit markets in the medium term is interest rates, and we believe that interest rates are almost certain to rise. They simply cannot remain this low. Quantitative easing by central banks has kept interest rates artificially low; as these easing programmes are reduced, interest rates should start to increase and normalise.
In addition, as the economic cycle turns towards recovery, inflationary pressures will start to build and interest rates will need to rise to alleviate this. Furthermore, emerging markets are now changing from being disinflationary providers of cheap goods to consumers in developed economies, to being significant consumers of goods themselves. This has increased the upward pressure on wages, agricultural, energy and metal commodity inputs into those economies.
One also needs to view the current interest rate environment in the context of long-term historical patterns. Current government bond yields are at their lowest levels for the past 140 years, levels seen only once before - in the aftermath of the Great Depression. It would be difficult to believe that interest rates could stay this low for an extended period, especially since inflationary pressures have been increasing.
This decline in interest rates has led to an increase in duration for all bonds, an increase that is now very significant compared with the coupon income on those bonds. A 50 basis point increase in interest rates now would wipe out the value of the coupon income of the Barclays Aggregate index, resulting in no returns over the next year. In 1990 that would have required a 200bp hike in rates. Given that US government bonds and US investment grade corporate bonds represent 80% and 18%, respectively, of the index, this situation does not bode well for either asset class.
The longer duration on bonds is especially troubling given the current forecasts for interest rates. Futures contracts for both long-term 10-year government bond yields and short-term LIBOR rates are indicating substantial increases in rates in the near future (by mid-January 2012 these markets predict a 10-year rate of 4.96% and a three-month rate of 2.88%). At this point in the interest rate cycle, anyone holding low-yielding fixed rate income products may be looking at a very difficult time for returns for the next few years - if not the next few decades.
At this point in the economic cycle where the economy and most financial assets are recovering, the opportunity in the credit space would generally be focused on securities which provide the upside of equities, namely convertibles and mezzanine debt, without being affected by rising interest rates (the coupon on mezzanine is typically LIBOR-linked).
Figure 5 shows that convertibles have the highest correlation with the MSCI World equity index. These securities would allow investors to participate in the recovery in equities while still have the downside protection of earning a yield. However, most investors’ fixed income portfolios are there to provide a counterbalance to the risks and volatility of equities, so adding credit securities with a high correlation to equities may not be a viable option.
With interest rates expected to rise substantially government bonds are expected to be negatively impacted the most, and figure 5 shows that the securities with negative correlations to government bonds are loans, since loans’ LIBOR-linked interest rate benefit from rising rates at the same time that government bonds are negatively impacted. As rates rise, assuming a parallel move in the yield curve, the value of a loan stays constant as its LIBOR-linked coupon increases, while the fixed coupon bond loses significant value when rates increase. In addition, loans have an added benefit in that they seem to have the highest correlation with inflation.
Loans are still trading below par (96 cents on the dollar as at 28 February 2011, according to Barclays POINT) and have not appreciated as much as other traditional fixed income asset classes, especially high yield bonds, despite recovering significantly since the bottom of the market. Loans are out of favour as the current low interest rate environment reduces their LIBOR-linked coupons.
The diversification benefits from introducing a combination of leveraged loans and high yield bonds into a portfolio of government and investment grade corporate bonds can increase the efficiency of a fixed income portfolio, increasing the expected return and the Sharpe ratio.
In conclusion, we believe that investors in credit securities need to rebalance their portfolios away from securities with high duration risk due to the potential for increasing interest rates and inflation in the overall economy. Some income investors may wish to benefit from the equity upside from the economic recovery, in which case they should target convertibles and mezzanine debt. The majority of credit investors merely want to hedge and diversify their fixed income portfolios to guard against rising interest rates and inflation.
Ray DeVoe of Legg Mason Wood Walker said after the bond market meltdown in 1994 that “more money has been lost reaching for yield than at the point of a gun”. People’s search for higher yields and higher returns often leads them to take a disproportionate amount of risk and causes them to lose money when a safer, lower return is available. We have been through a three-decade period of declining interest rates and are now at the point where short-term real yields are negative and require deflation to justify their current levels. Investors should be wary of yielding investments which lock them in at the current low level of interest rates and should instead focus on investments which benefit from a normalisation back to higher rates. As such, we believe that investors should consider selling down their government and investment grade corporate bond portfolios, which have the greatest duration risks and adding senior loans and some high yield bonds. This would not only provide greater protection against interest rate rises, but it would also increase the long-term returns and Sharpe ratios on their portfolios.
Roy Kuo is head of research and Emily Upson a research analyst at Dexion Capital. This is an edited version of a research note first issued in March 2011