High yield bonds have suffered more than most asset classes during the credit crunch. Given the risks associated with anything close to junk status, they are currently well off the radar screens of most institutional investors. That’s particularly true in Asia, where there is not so much understanding of the asset class.
The market for high-yield corporate debt - made famous in the go-go days of Michael Milken and Drexel Burnham Lambert in the 1980s – is poised for a significant rally, according to fund manager and analyst Martin Fridson.
“The high-yield market has been around about as long as I have, since the mid-1970s,” Fridson said at a briefing in Hong Kong. “In that time I have not seen an opportunity comparable to what we see today, and I don’t expect to see another comparable one in my working life.”
Fridson, the CEO and co-chief investment officer of New York-based Fridson Investment Advisors, also believes there is a strong argument for the diversification benefits of junk bonds in an institutional portfolio.
The correlation of different kinds of bonds is normally very high, even when you are comparing Treasuries with investment grade corporate debt, which have a correlation of around 86%. But high-yield bonds are much less correlated with other bonds, showing a correlation of 51% with investment grade debt and only 16% with Treasuries.
As a result, a model portfolio that is made up 85% of Treasuries and 15% of high-yield debt produces smoother returns over the last 10 years, Merrill Lynch data show, than even a portfolio made up 100% of Treasuries.
“You get a very significant diversification benefit by including high yield with other bonds,” Fridson said. “The correlation between high yield and stocks is actually slightly higher than they are with the other bond categories. If this was widely understood we would see much higher holdings of high yield bonds by institutional investors.”
He is putting BNP Paribas’ money where his mouth is. The French asset manager has allocated US$200 million to the newly formed Fridson Investment Advisors and its high-yield bond hedge fund, which launched last June.
The fund currently has a total of $240 million under management, though director of business development Sean Bailey says it is targeting to raise $2.5 billion.
“We didn’t pick to launch at this time, but we do have the timing on our side,” Bailey said. “We’ve raised the cash, we are out there looking for opportunities, and we are out there playing offense.”
With a two-year lockup on the BNP Paribas investment, the partners believe now is the perfect opportunity to be accumulating high-yield bond assets, at a time many managers are seeing redemptions. The market is also being priced as if all high-yield bonds were in default. “The upside is really remarkable,” Fridson said.
In October 1990, the Merrill Lynch High Yield Master II fell to a low of 71.085 and then proceeded to soar 39.7% over the next year, the greatest rally on record. The index is now lower than the starting point of those heady gains, sitting at 63.945 in March.
Fridson’s research suggests high-yield bonds are due to rally 56% from these lows. The real issue is timing, and how long that rally might take. Even if that rebound takes three years, though, investors would still be looking at total returns of at least 13% per year. In the meantime, they are generating a yield of 10% on the bonds themselves.
“If you have to wait a while, you are getting paid pretty well to wait,” Fridson said.
Other analysts and market watchers have also suggested that the credit markets rather than equities may show the first signs of recovery in 2009. James Grant, the editor of Grant’s Interest Rate Observer, for instance, has stated that current credit prices reflect too much pessimism, leading him to recommend investors to skip Treasuries in favor of a portfolio combining investment grade corporate debt with high yield corporate bonds.
The high-yield market has already started to show some signs of life after a savage 2008. In December 2008 and January 2009, the Merrill Lynch High Yield Master II Index jumped 13.0%. Only once before, in February and March 1991, had the index posted a better two month patch, up 13.9% at that time.
High yield bonds dipped again this February and in March. But their depressed level may leave them positioned for a rally. Moody’s Investors Service is already forecasting a 15.5% default rate over the next 12 months, higher than the 11.1% rate recorded in the year through October 1991, during the last major downturn in high-yield debt. That indicates plenty of bad news is already priced into the market.
“We have almost no one who questions that the value is very good,” Fridson said. “I realize investors are concerned with price risk, and many are trying to get in at the bottom. The problem with that is everyone will try to get in at the same time, and the market will rush up very quickly.”