Robert J Manning of MFS argues that tough questions and fundamental research are core to
the investment decision
While much of the investment world's attention has been rivetted on the stock market for the past several years, another growing, dy-namic market has been providing some very attractive returns. This is the US high-yield bond market, in which corporate bonds are unrated or have received lower credit ratings from independent rating agencies such as Standard & Poor's and Moody's Investors Service. While the slowing global economy has exposed some of the risks of this bond market, it is still seen as a good place to achieve some relatively attractive fixed-income returns while offering companies a place to raise much-needed capital.
In the 1970s and early 1980s, the term 'high-yield' was synonymous with 'junk,' because many of the companies that were in this market got there because their credit ratings had been downgraded to below-investment-grade status. Today, for many invest-ors, the very thought of high-yield bonds conjures up memories of the late 1980s when the market for these bonds was dominated by one major brokerage house. When that firm collapsed, the high-yield bond market all but collapsed with it.
However, an important lesson had been learned. High-yield bonds had shown that they could be a legitimate vehicle for young companies and for established companies with higher-than-average debt structures to gain access to the capital markets. As a result, since 1990, when only $1.4bn in new high-yield bonds was issued, this market has exploded to the point where over $118bn of new high-yield bonds was issued in 1997.
Today, many of the companies in the high-yield market represent some of the most dynamic, fastest-growing industries in the world. For example, one of the most dynamic is telecommunications. In 1996, the US Congress deregulated both local and long-distance telephone service, creating a new industry, the competitive local exchange companies. Already several of these companies that got their initial funding from the high-yield bond market have experienced rapid growth and several, including Brooks Fibre and Teleport, have been bought out by investment-grade companies. Going forward, we believe that the multibillion-dollar local and long-distance telephone business, along with Internet and related telecommunications companies, will create tremendous opportunities.
Another major player in the high-yield market is aerospace, where companies that make products like brakes for airliners, airline seats, hydraulic pumps and actuators, are benefiting both from aircraft renovation and from orders for new commercial aircraft.
In spite of the growth of the high-yield market, it is important to keep the risks of these bonds in mind. They do, for instance, carry higher credit risk than investment-grade corporate bonds. A company could become bankrupt and fail to make the interest or principal payments due to its bondholders. With
U S Treasury bonds, by comparison, there is no credit risk because the US government has never defaulted on the interest or principal payments due on its bonds.
Still, all types of bonds, even Treasury bonds, have interest rate risk. If interest rates rise, the value, or price, of outstanding bonds offering lower rates declines. However, high-yield bonds may actually have less interest-rate risk than US Treasury bonds. That's because prices of Treasury bonds are almost entirely affected by changes in interest rates, while other factors, such as the state of the economy and credit quality of the issuing company, can affect the price of high-yield bonds. So in a growing economy, for instance, interest rates may be falling, reducing the prices of Treasuries. However, prices of corporate bonds, including high-yield bonds, may not decline as much because investors' concerns about the companies' credit quality and ability to meet their debt payments are reduced. Even though changes in interest rates have a greater impact on Treasury prices, the Treasury market is still the benchmark used to evaluate the attractiveness of yields in the high-yield market.
In recent years, the average yield on high-yield bonds has ranged from approximately 3% to 4% over Treasuries. This year, however, the global economic turmoil has caused this yield spread to widen, to about 5%. The major reason for this is a 'flight to quality' as investors are moving money away from high-yield bonds and toward what they see as the safest places for their money, that is, the Treasury market. This has created a liquidity problem which has impacted almost all non-Treasury markets, but has had a greater affect on markets where there is a perception of greater risk.
However, 'perception' is an important word here, because even though the high-yield market is perceived as having more risk right now, many of the companies in this market are actually in fairly good financial shape. They may not be the first- or second-largest companies in their industries, but their businesses are doing well and they are meeting their debt payments.
Still, given the growing uncertainties of the world's financial markets, investors have to ask themselves: How are these companies going to do six months or a year from now? Getting the answer to that question means staying on top of the trends affecting these companies and their industries.
Even before that, it is vital to undertake a thorough, fundamental research process of each company being considered for a high-yield portfolio. Asking a lot of tough questions when times are good can help avoid problems when the inevitable downturns arrive. At MFS, we use a five-step process to analyse each company being considered for our high-yield portfolios:
First, we assess the company's management. That means meeting with the managers to learn what their strategy for the company is and to try and determine their ability to execute that strategy. We also like to see managers have equity in their own companies, so if something goes wrong they have something at stake.
Second, we look at cash flow. Stock analysts focus on a company's earnings, but for us, stable cash flow is more important. We want to see how much cash is coming in, how much is going out, and how well the company is meeting its debt ob-ligations.
Third, we look at a company's asset value. We like companies that have hard, fixed assets, like buildings, machinery, or equipment, that have value if something goes wrong. Regardless of how a company fares financially, their plant, equipment, and real estate will generally have some value to a potential buyer in a merger or acquisition.
Fourth, we want to know where the bonds we are buying are in the capital structure. Companies can issue senior bonds and junior bonds. While junior bonds have higher yields, holders of senior bonds have a higher claim to the company's assets if the company goes bankrupt. If we think there is little risk of default with a particular company, we may seek the extra income from junior bonds. But if the default risk seems higher, we'll buy the senior bonds.
Finally, we look for positive industry trends. We not only use our own high-yield analysts, but also MFS' equity analysts to increase our knowledge of developments in all industries and the relative positions of companies within those industries. Over time, we have learned that we may do better by investing in a weak or even mediocre company in a growing industry than by selecting a good or even great company in a declining industry.
The high-yield market, like the stock market, has enjoyed several years of very strong returns. In the high-yield market, people have been paid to take on an enormous amount of credit risk. But as the economic slowdown continues through 1998 and into 1999, we expect more credit problems to appear. In this environment, solid, fundamental research will become even more vital to find the higher-quality businesses with the financial strength to weather the downturn.
Robert Manning is senior vice president of MFS Investment Management and portfolio manager of MFS High Income Fund in Boston
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