With high-quality bond yields near all-time lows, investors have been pouring into high-yield bonds at a record pace. Although this has fueled concerns about an overheated high-yield market, Allianz Global Investors believes investors would be better served by thinking of high-yield bonds as more of a strategic allocation for the long term than a tactical allocation for today. High-yield bonds have turned into a legitimate asset class that is larger, better established and less risky than in years past, providing evergreen benefits that make them a sound addition to most diversified portfolios. In addition, the current environment is still attractive for high-yield bonds as a whole – and active managers with rigorous credit research processes can help investors best maximize the risk / return potential of this important asset class.
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What are high-yield bonds?
High-yield bonds and investment-grade bonds are the two segments of bond debt, known collectively as corporate bonds, that are issued by public and private companies to access credit markets and raise capital.
• Investment-grade bonds are issued by the most creditworthy issuers. They have ratings of between “AAA” and “BBB–” (or the equivalent) and their interest rates are slightly higher than those of government bonds.
• High-yield bonds are issued by less-creditworthy companies, as determined by the widely accepted evaluations of several major ratings agencies. They have ratings of less than “BBB–” (or the equivalent) and their interest rates are considerably higher than those of government bonds to make them more attractive to potential investors.
The creditworthiness of a corporate bond issuer is rated by ratings agencies such as Standard & Poor’s, Moody’s and Fitch. Their ratings are designed to precisely reflect levels of credit risk – the risk that an issuer may default on payments. Ratings are reviewed at least once a year and can be maintained, upgraded, downgraded or placed “under review” with “positive” or “negative” implications, pending completion of an additional study. The “spread” of high-yield bonds – the yield differential between high-yield bonds and government bonds – is primarily dependent on the creditworthiness of the issuer. Experienced high-yield bond investors look for securities whose creditworthiness is likely to improve – i. e., “upgrade candidates.” An improvement in an issuer’s creditworthiness warrants a lower spread, which tends to result in a lower overall interest rate and an increase in the value of the securities. Conversely, it is important to avoid bonds whose creditworthiness will deteriorate: A drop in creditworthiness warrants an increase in the spread, which tends to result in a higher overall interest rate and an automatic decline in the value of the securities.
High-yield bonds, past and present
While high-yield bonds are portfolio staples for many investors, they can also be underutilized or ignored by others. This may be at least in part due to some commonly held misperceptions about an asset class that has changed significantly in recent decades.
Yesterday: An immature market. A brief boom.
Before 1977, almost all high-yield bonds (known as “junk bonds”) were “fallen angels” – bonds issued by firms that originally had investment-grade ratings but had since been downgraded, which indicated a heightened possibility of default. In 1977, however, new-issue high-yield bonds were introduced to the marketplace, and the asset class soon began to boom. The new market was in large part created by investment bank Drexel Burnham Lambert and its star trader, Michael Milken, who offered a new way for many firms – considered “bad” investments and starved of capital by banks – to gain access to credit. In the 1980s, Drexel’s legal difficulties and other scandals severely tarnished the reputation of high-yield bonds, and the high-yield market dried up in the face of rising interest rates, rising defaults and a new regulatory environment.
Today: A mature market for a new environment
In the last few decades, the environment for high-yield bonds has changed dramatically.
• US high-yield bond gross issuance was only $150 billion in 1990 – but by 2012, it was over $1.3 trillion.
• 40 % of all outstanding corporate bonds are now high yield.
• The US makes up the largest portion of the global high-yield corporate bond market.
• US high-yield issues represent a well-diversified universe. Unlike in previous years when high-yield bonds were concentrated in certain sectors, no single industry dominates the high-yield universe today.
• Companies today rarely use proceeds for takeovers or new investments relative to history; instead, they’re refinancing balance sheets and reducing borrowing costs, which reduces the risk of default.
Benefits of high-yield investing
The evolution of the high-yield debt market makes it a legitimate asset class for diversified portfolios, and cements the role of high-yield bonds as an important strategic allocation. We believe there are three primary benefits of high-yield investing: income potential, risk diversification and positioning against inflation and rising rates.
High current yields fill a need for income
With historically low interest rates, high-yield spreads are currently approximately 531 basis points over Treasuries (Source: BofA Merrill Lynch and Allianz Global Investors, as of 31 Dec. 2012). This gives high-yield bonds a significant yield advantage over Treasuries, which are currently so low-yielding that their real returns may actually fail to keep up with inflation. Of course, Treasuries are the only investments guaranteed by the US government as to timely repayment of interest and principal, but investors are finding attractive income opportunities with high-yield bonds.
High-yield bonds provide portfolio risk diversification
In addition to a high and steady stream of potential income, high-yield bonds can provide other benefits to a portfolio: High-yield bonds have a favorable risk / reward profile when compared to more traditional asset classes – including large-cap US stocks, smallcap US stocks and international stocks – providing equity-like returns with much less volatility. High-yield bonds are generally less volatile because they provide a steady stream of income that provides a cushion in periods of market weakness. Also, adding high-yield bonds to a fixed-income allocation can help reduce risk and increase potential returns over the long term.
High-yield bonds help investors combat inflation and rising rates
Should interest rates rise from today’s historic lows – as they inevitably will – an allocation to high-yield issues would be an obvious choice. High-yield bonds have shown a tendency to hold up better than other types of bonds, particularly Treasuries. However, it’s important to keep in mind that bond prices will normally decline as interest rates rise and the impact may be greater with longer duration bonds.
We believe the reason for high-yield bonds’ ability to perform more like stocks during rising-rate cycles may be that, much like stocks, high-yield bond returns are closely correlated to the business successes and fundamentals of their issuing companies. This closer link to business fundamentals means that when interest rates rise, high-yield bonds tend to outperform investment-grade bonds, since interest rates tend to rise when business conditions are robust.
While there has been concern about the possibility of an overheated
high-yield bond market, we believe there are compelling reasons why the outlook for high-yield bonds remains strong.
Strong historical performance when spreads are low
Although high-yield spreads have come down significantly from their recent highs, low spreads have historically been accompanied by prolonged periods of compelling highyield performance as corporate fundamentals improve. This causes the prices of high-yield bonds to rise, which can boost total return.
Default rates are low
The fundamentals in the high-yield market have greatly improved since the credit crisis of 2007 – 2008: Balance sheets are stronger, leverage is lower. As a result, the main risk associated with high-yield bonds – defaults – has diminished in recent years, from a historical 4 % to today’s 2 % (Source: BofA Merrill Lynch, JP Morgan and Allianz Global Investors, as of 31 Dec 2012). Defaults have been much higher during previous periods – most recently, during the credit crisis of 2008 – but we believe the probability of default rates rising significantly from current levels in the next 12 months is minimal. Investors should also note a key difference between high-yield bonds and stocks: Bondholders are higher in the capital structure. That means if bankruptcy occurs, high-yield bondholders, who are lenders, would be paid ahead of stockholders, who are owners.
How high-yield bonds fit into an asset allocation strategy
With the establishment of high-yield bonds as a legitimate asset class that is larger, better established and less risky than in years past, we believe there are compelling reasons why investors should consider a long-term allocation to a portfolio of actively managed high-yield issues.
High-yield bonds are an attractive addition to almost any portfolio allocation
As we have shown, high-yield bonds have historically provided high current income potential, improved risk / reward profiles and provided solid positioning against rising rates. Yet to the detriment of long-term investors, many basic asset allocation models are unallocated, underallocated or misallocated to high-yield bonds. Traditionally, investors have relied heavily on fixed income to generate an income stream in their portfolios. But as interest rates have tapered off in recent years, so have the yields that investors earn on conventional bonds. In fact, the yield on a traditional “60 / 40” portfolio of 60 % stocks and 40 % bonds is near its lowest level in 35 years. Historically, investors who have looked beyond this conventional investing framework and added high-yield bonds to 10 % of their portfolio have found increased returns with less risk and a superior Sharpe Ratio. Using an asset allocation strategy does not assure a profit or protect against loss. Investors should consider investors investment time frame, risk tolerance level and investments.
Passively managed high-yield ETFs vs. actively managed high-yield portfolios
While exchange-traded funds (ETFs) are gaining acceptance as efficient ways to access many asset classes, they are not always the optimal investment vehicle for high-yield investing. Because of the high-yield marketplace’s unique characteristics, passively managed high-yield ETFs may actually have significant disadvantages compared with actively traded high-yield portfolios. For example, ETFs are meant to closely track indexes, but, unlike equity ETFs, which usually own all of the stocks in a benchmark, fixedincome ETFs hold significantly fewer issues than the indexes they’re tracking, which often contain thousands of individual securities. Case in point: One major high-yield index, the BofA Merrill Lynch High Yield Master II Index, represents 2,112 high-yield holdings as of 31 Dec 2012. To mirror the general characteristics of the index without holding all of the 2,000+ securities, a high-yield ETF would likely hold the largest, most liquid and most recent new issuers. Like ETFs, actively managed portfolios may not fully represent an index or may be over- or underweight certain securities. However, unlike ETFs, many active managers look for issuers they believe to have upgrade potential or the best perceived creditworthiness. In addition, when high-yield markets are stressed, trading can become an issue for ETFs if secondary trading volume fails. That’s because ETFs must make good on cash deliveries every day, even during market downturns. If an ETF shareholder redeems shares, the ETF must provide proceeds. But when markets are dropping, ETF traders can encounter unfavorable “bid / ask” spreads yet must still take the price available that day. Of course, unlike actively managed portfolios, which only allow for redemption at the end of the day regardless of market activity, ETFs offer the ability to redeem midday. Moreover, active managers who use bottom-up, fundamental research may be able to reduce their exposure to riskier bonds before markets become overly stressed in the first place.
Managers of actively managed high-yield portfolios can take direct steps to seek to improve outcomes for their shareholders, although there is no guarantee these strategies will be successful. Unlike ETFs, active managers:
• Assess credit quality with thorough analysis. Examining an issuer’s sector, market positioning, strategy, balance sheets and financial statements helps the manager determine if the company’s dayto- day operations will allow it to service its liabilities adequately over the long term.
• Verify that spreads match creditworthiness. When they determine that the spread underestimates the creditworthiness, they may decide to invest more; if the spread is insufficient, they can reduce their holdings.
• Look for upgrade candidates. As we previously mentioned, it’s important to hold securities whose creditworthiness is likely to improve. Any improvement in an issuer’s credit rating tends to result in a lower overall interest rate and an increase in the value of the securities. • Can diversify their portfolios between sectors and companies instead of seeking to replicate an index. Of course, diversification does not assure a profit or protect against loss.
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