Reaping the rewards
Todd Ruppert of T Rowe Price reckons that conditions may be ripe for a market upturn for US high yield bonds
EUROPEAN fixed income investors looking for new spread products are discovering that US corporate high yield bonds can be an attractive asset class. Although Europe does have a growing corporate high yield sector, that market is still in its infancy. There are too few issues for prudent diversification, and most issues are still too unseasoned to have gained investor confidence.
As a result, European institutional investors are now investigating US high yield bonds. These bonds, also known as “non-investment grade” corporate bonds, can sound very risky to the uninitiated. But a closer examination of the risk/reward characteristics of high yield bonds, and of their low correlation with other asset classes, shows that they can provide a highly beneficial level of yield, return and diversification for an institutional portfolio.
Attractiveness of US High Yield Bonds: The first attractive quality about the US high yield bond market is that it has been in existence for almost 15 years. It is a large and well-established market with significant liquidity and excellent breadth that encompasses approximately 25 industries. Today it is a $625bn market with over 3,000 issuers. Many issuers are proven, market-tested names such as Avis Rent-a-Car and Nextel Communications.
Second, high yield bonds have performed well on an absolute basis. During the period January 1 1990 through September 30 1999, BB and B rated bonds produced far better returns than investment grade bonds. B rated bonds achieved cumulative returns of about 190% over the period (11.5% per annum), followed by BB rated bonds at 180% (11.1% per annum). This represents a 30%-plus return premium over the average investment grade corporate bond. Although the high yield bond market environment has been challenging during the last two years, BB and B high yield bonds have continued to outperform the investment grade bond market (see Table 1). In part, this is because high yield bonds are not as interest-rate sensitive as investment grade bonds.
Third, high yield bonds also offer investors attractive relative returns on a risk-adjusted basis. Many investors believe that high yield bonds entail an exceptional amount of risk, but it is important to realise that this is not necessarily true.
One way to quantify risk so that it can be compared across asset classes is through the Sharpe ratio, which measures excess return per unit of volatility. Using this measure, US high yield bonds have been more attractive than most other asset classes – including US investment grade bonds, US Treasury bonds, mortgages, and even the S&P 500 Index of US equities – over the last 13 years. (Most of the widely-used high yield indexes have been in existence since mid-1985 – hence the unusual choice of a 13-year period for our chart.)
As Figure 1 demonstrates, the high yield market has returned nearly 11% per year on an average annualised basis during this period. This return is quite attractive in absolute terms, and is more than 100 basis points ahead of the absolute annualised return for investment grade bonds. Figure 2 shows this same performance on a risk-adjusted basis, using the Sharpe ratio. When risk is factored into the analysis, not only do high yield bonds continue to outperform investment grade bonds, they also outperform common stocks.
Fourth, high yield bonds are a good tool for diversifying a portfolio because of their low correlation with other fixed income and equity instruments. Adding high yield bond exposure can increase portfolio returns while lowering overall volatility, making high yield bonds an excellent addition to many institutional portfolios.
Finally, the maturity of the market has also allowed for the creation of profitable structured investment products that incorporate high yield bonds. Collateralised bond obligations, or CBOs, offer institutional investors a variety of investment grade quality debt instruments which are secured by a diversified portfolio of US high yield bonds. These deals, which can be rated as high as AAA in quality, are a prudent, indirect method of participating in this asset class. CBOs have gained increasing acceptance among European institutional investors over the last three years.
The Advantages of US High Yield Bonds Over European High Yield Bonds: US high yield bonds offer several advantages over their European cousins. First, they constitute a deep and broad market. A prudently managed high yield bond portfolio requires broad diversification across industry sectors and issuers, and this diversification is more readily achieved in the US than in Europe. The $625bn US high yield universe provides meaningful exposure to about 25 industries, versus the small handful of industries currently available in Europe. The US universe also represents about 3,000 issuers – 30% BB rated, 60% B and 10% CCC – as compared to a total of only about 60 European issuers. Other factors, such as a limited number of market participants and a smaller average deal size, have a negative effect on the liquidity of the European high yield bond market.
Another important point is that the US high yield bond market potentially offers stronger, well-tested legal protection to bond investors. In the event of corporate insolvency, Chapter 11 of the US bankruptcy code gives even unsecured creditors an opportunity to recover a portion of their losses. By contrast, when bankruptcy threatens in Europe, banks often have the ability to seize control of the company’s secured assets and liquidate them to protect their own interests.
High Yield Bond Risks: The most obvious risk in high yield bond investing is credit risk. The average annual default rate over the past 13 years has been about 2.5%, and during the first nine months of 1999 that rate spiked to 4% on an annualized basis. Most of the 1999 defaults have been occurring in the CCC rated sector, with a sprinkling of Bs. There have been very few defaults among the BBs. Furthermore, the default rate is not uniform among industry sectors. Year to date, 71 companies have defaulted on their high-yield debt, and of these, energy companies, at 10 defaults, lead the industry list. Other hard-hit industries include textiles, paging, and long-term health care.
Clearly, credit risk is a major concern in the high yield universe. However, it is equally clear that a portfolio that is well diversified by industry and issuer, and that focuses its holdings in the B-BB range can largely mitigate the risk of default.
Besides credit risk, the other major risk is liquidity. Many underwriters have found it difficult to make orderly markets in today’s rapidly-expanding high yield universe. Recently spreads have widened, in part to compensate for the greater liquidity risk. The ability to “source” liquidity in order to achieve cost-effective trade execution is crucial in such an environment, and makes in-house trading expertise vital for the portfolio manager.
From the vantage point of European investors, there is also a lesser concern of currency risk. Investors can manage a significant portion of currency risk simply by investing for the long term. It is also quite possible that the Euro/dollar exchange rate may operate in a narrower band in the future, given that the central banks in both Europe and the US are maintaining a policy focus on low inflation and reduced volatility in the business cycle.
Managing the High-Yield Bond Portfolio: A carefully considered high yield investment process will incorporate four themes:
1. In-depth research;
2. Portfolio diversification;
3. An orientation towards higher-quality high yield bonds; and
4. A strict sell discipline.
First, the high yield bond market demands in-depth research. A detailed understanding of corporate fundamentals is the key to understanding the risks posed by each issuer. Good insights are based on frequent interaction with the companies under study, both by phone and through on-site visits. Proprietary research is crucial as a means to obtain independent verification of issuer-provided data.
The research process can be enhanced by close co-operation between committed high yield bond professionals and equity analysts. Equity analysts can provide a fresh analytical perspective as well as access to top corporate executives, something that an isolated high yield bond team may not always be able to obtain.
The second requirement in managing high yield bonds is to provide additional risk control through broad diversification, both by individual issuers and by industry sectors. Diversification effectively reduces volatility minimising the impact of any single credit event on the portfolio. Managers should maintain strict investment guidelines to assure diversification. For example, at T Rowe Price, our average exposure to any one issuer is 1% or less. We likewise tend to keep our industry exposure at 10% or less.
The third theme is that success is on the side of a conservative approach when it comes to credit quality. A large number of significant opportunities lie in BB rated debt. At the same time, the default rate of BBs has been much lower than that of B and CCC rated bonds, making BBs a logical starting place for the conservative investor looking at this asset class for the first time.
Finally, sound portfolio construction counts for little if the manager does not also establish and follow a strict sell discipline. Research identifies a holding at risk; diversification keeps each individual holding relatively small; and a focus on higher credit quality helps to preserve liquidity. The piece that brings this puzzle together is an experienced and dedicated trading staff. Experienced high yield traders establish a broad range of relationships in the broker/dealer community and maintain those relationships through all market conditions, ensuring that problem holdings have the best possible chance of moving out of the portfolio at the best possible prices. Likewise, solid relationships ensure the best price for a successful holding when it comes time to lock in profits.
The Current High-Yield Environment: US high yield bonds have gone through a frustrating period during the last two years. The market is now suffering growing pains; in 1998 alone, close to $150bn in new high yield bonds were issued. Some of these newer deals were of suspect quality, and a number of those companies are already beginning to default on their obligations. However, new supply has depressed prices and increased yields across the board, creating opportunities to acquire higher quality high yield bonds at attractive prices.
Historically, the high yield bond market has experienced long stretches of low volatility punctuated by short periods of hyper volatility, and the second half of 1998 was one of the volatile times. Russia’s default, Long-Term Capital Management’s problems, and an emerging markets crisis around the world caused a tremendous liquidity squeeze in high yield bonds. Prices plummeted and spreads spiked up, peaking in October 1998.
After the Federal Reserve Board cut interest rates and confidence was restored, the market responded with a rally. Spreads declined substantially, though not to pre-crisis levels. But the rally faded after the first quarter of 1999. Since April 1999, high yield bonds have suffered from too much supply and a lack of liquidity. Y2K challenges have also created uncertainty in the high-yield market that are likely to linger for the remainder of 1999.
We believe, however, that conditions are now ripening for a market upturn. Widening spreads and rising defaults have slowed the flood of new issues, and the market is beginning to digest its recent additions. Y2K fears will, by definition, subside after the calendar changes. The US economy remains robust, and the outlook for growth remains good. Inflation is still well-controlled. Recent business trends, such as the surge of merger and acquisition activity, favour high yield bonds because stronger companies tend to buy weaker ones, creating the potential for credit upgrades for the debt of acquired companies.
From September 30, 1996, through September 30, 1999, the average spread between BB rated bonds and US Treasuries was about 250 basis points. However, BBs are currently trading at about 350 basis points over Treasuries, an attractive 40% premium to the normalised historical relationship. Furthermore, many high yield bonds are trading at wide discounts. This means potential capital appreciation as well as high current yields as the market steadies itself. So, while we think this difficult environment may persist into early 2000, we also perceive current conditions as an opportunity for the new investor.
With the US high yield bond market approaching its 15-year anniversary and enjoying phenomenal recent growth, this asset class is certainly here to stay. If the projected market stabilisation expected for first quarter 2000 materialises, European investors who explore this sector may be richly rewarded.
Todd Ruppert is managing director of T Rowe Price Associates in Baltimore