US high yield bonds: an overview
After a volatile and often difficult year for world financial markets in 2000, investors have lately sought safe havens for their assets in traditional sectors, such as government bonds, value stocks, and real estate. Economies around the world have been showing signs of slowdown, and even after recent cuts in US interest rates, analysts are predicting that at least another full quarter or more will pass before we begin to see the effects ripple through to boost economic activity.
Like many stocks, high yield bonds experienced an up and down year. Mounting levels of debt and slowing revenue growth have been the primary causes of investor concern. The European market, dominated by telecom issues, has been pressured by the auction of ‘third generation’ (or 3G) wireless licenses, which went for record bids in markets across the continent. Many of the region’s most promising telecom companies are now deeply in debt as a result. In the US, where 3G auctions have yet to occur and telecom issues are not as dominant, balance sheet leverage has been created by companies anxious to buy back stock or achieve competitive mergers. High yield issues across the board suffered as investors pulled money out of these bonds and liquidity in the secondary market dried up.
In such a risk-averse, slow-growth environment, why should an institutional investor consider high yield bonds? The answer is that high yield bonds, particularly in the US market, can be an attractive asset class even in this environment. High yield bonds have historically provided a prudent degree of fixed income portfolio diversification and strong risk-adjusted performance. Given current depressed prices in the high yield market, now may prove to be a particularly appropriate time for institutional investors to investigate this asset class.
The advantages of US high yield bonds
At first glance, European high yield bonds appear to offer the same advantages as US high yield bonds in providing an attractive alternative to traditional government bond investments. Their combination of high current yields and strong potential for capital appreciation potential is compelling. However, prudent investors need to examine the differences between the two markets as well.
At over $650bn in par amount outstanding, and with more than 15 years of performance history, the US high yield bond market offers significant depth and issuer/industry diversification. The market encompasses more than 3,500 high yield issuers representing over 30 industries. There are at least 70 individual issues of $1bn or more. And the US high yield market is mature, now comprising over 20% of the total US corporate bond market (see Figure 1).
By contrast, at year end 2000, according to Chase Securities and Credit Suisse First Boston, the European high yield bond market totalled approximately $47bn in par amount outstanding – less than one-tenth the size of the US market. At last count there were only 250 high yield issues in the market, and of these, only 12 totalled $1bn or more (see Figure 2).
Support for the rapid development of Europe’s high yield market can be seen in the expansion of the range of industries represented. Three years ago, only eight industries had high yield bonds outstanding; today, there are 25. But despite this broadening of the market, the media and telecom industries still represent almost 60% of European par amount outstanding, as compared with 30% in the US high yield market. Diversification and liquidity are thus still very difficult to achieve in the European market.
Another key difference between the two high yield markets is the lack of a natural long-term buyer base in Europe. A natural buyer base, which consists of investors who seek deep value opportunities, helps stabilise the market during times of correction.
Last year was the first real correction the European high yield market has experienced since its inception. The US high yield market has experienced four significant corrections in its history, during 1989–90, 1994, 1998, and 2000. The benefits of maturity and diversification were clearly apparent in the very different performance of the two markets during 2000. The Chase European High Yield Index declined by 12.67%, versus a decline of 5.68% for the Chase Global High Yield Index (which is heavily weighted towards US issues).
Value investors and CBO funds have acted as natural buyers for the US high yield market during these periods of stress. With time, we do expect the European market to develop a similar natural buyer base.
Attractive absolute returns
US high yield bonds have performed well on an absolute basis. During the period 31 December 1989 through to 31 December 2000, US BB and B rated corporate bonds produced cumulative returns that far outpaced those of US investment grade bonds. B rated bonds achieved cumulative returns of 172% over the period (9.53% per annum), while BB rated bonds returned over 193% (10.27% per annum). This compares to average annual returns of 7.99% - 8.53% over the same period for investment-grade bond categories (see Figure 3).
For the 10-year period ended 31 December 2000, the CS First Boston Global High Yield Index had an average annual return of 11.20%. This compares favourably to the Lehman Brothers Corporate Investment Grade Index average annual return of 8.41%, and the Salomon Smith Barney World Global Bond Index average annual return of 6.98%. Consider also that on the equity side, the MSCI World Index returned 12.43% in average annual performance over this same period. For investors seeking good returns from an income-producing investment, the track record of high yield bonds versus both other bonds and versus equities is compelling (see Figure 4).
Attractive risk-adjusted returns
Many are surprised at how attractive high yield returns can be on a risk-adjusted basis. Investors tend to believe that high yield investing entails 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. The higher the Sharpe ratio, the greater the excess return per unit of risk. Measured by this ratio, US high yield bonds have been more attractive than most other bond and equity asset classes – including US investment grade bonds, global investment grade bonds, the MSCI World Index, and the S&P 500 Stock Index – over the last 10 years.
The fact is that, on a risk-adjusted basis, US high yield bonds have outperformed all of the usual institutional asset allocation categories. The US-based Salomon Smith Barney BB/B Index ranks highest of all, followed closely by the US-dominated CS First Boston Global High Yield Index (see Figure 5).
There is also a performance benefit through the diversification high yield can provide for a fixed income portfolio. This is due to high yield’s low performance correlation with other fixed income instruments. Low correlation results from the relatively low sensitivity high yield bonds have to interest rate changes. Thus, including US high yield bonds can help offset cyclical performance dips in a fixed income portfolio while lowering overall volatility, as the performance and Sharpe ratio data we have cited indicates. This makes high yield bonds an excellent addition to many institutional portfolios (see table).
Finally, the maturity of the US high yield market has allowed for the creation of profitable structured investment products that capture much of the high yield performance premium at greatly reduced risk. 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 AAA in quality, can be a prudent, indirect method of participating in the high yield asset class. As more of these deals come to market and establish sound performance records, CBOs will gain widespread acceptance among European institutional investors.
Risks and risk management
The most obvious risk in high yield bond investing is credit risk. The average annual default rate over the past 15 years has been about 2.6%, a rate that spiked to over 5% in 2000. Most defaults over the past two years have occurred among CCC quality debt, with a sprinkling of B ratings. There have been very few defaults among BB rated credits. Historically, a conservative, higher credit quality approach to the high yield market has tended to mitigate the credit risk.
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 between high yield bonds and benchmark securities, such as the 10-year US Treasury bond, in part to compensate for greater high yield 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.
Management of risk is clearly needed in order to reap the full benefits of a high yield investment. A carefully-considered high yield investment approach should incorporate four major elements:
q in-depth research;
q portfolio diversification;
q orientation towards higher-quality high yield bonds; and
q 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 also crucial as a means to obtain independent verification of issuer-provided data.
The research process can be enhanced by close cooperation 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 issuer and by sector. Diversification effectively reduces volatility by reducing the impact of any single credit event on the portfolio. Managers should maintain strict guidelines to assure diversification.
Third, a conservative approach in selecting credit quality can improve the odds of attaining superior performance over time. 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 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, creating the kind of reputation that will help the portfolio manager move problem holdings 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.
A $650bn asset class is one that institutional investors should not overlook. Over time, US high yield bonds have generated attractive absolute and risk-adjusted returns. Moreover, the best returns historically have come immediately after periods of unusual stress, similar to the situation the market is experiencing today. We believe that 2001 is an advantageous time for institutional investors to examine the potential benefits high yield bonds can bring to their portfolios.
R Todd Ruppert is President and CEO of T Rowe Price Global Investment Services Ltd.
© 2001, the T Rowe Price Group. The T Rowe Price Group includes T Rowe Price Global Investment Services Limited, T Rowe Price Associates, Inc, T Rowe Price International, Inc, and T Rowe Price Stable Asset Management, Inc. T Rowe Price Global Investment Services Limited is located at 60 Queen Victoria Street, London EC4N 4TZ, and is regulated by IMRO