Record low rates and rock-bottom yields have forced many investors to consider corporate bonds.
But fallen angels or start-ups are more likely to default, lose liquidity or downgrade. Fortunately, such risks are more controlled these days, says Phaby Utomo, senior private wealth manager at UBS Wealth Management. That’s due to greater transparency among companies, tighter controls around accounting mechanisms and increased analyst coverage.
Recessions can be the biggest enemies of high yield. But, Utomo doesn’t foresee one afflicting the U.S., the largest high-yield bond market, in the near future. “That should prevent any sharp rise in default rates,” she says. “The default rate of U.S. high-yield issuers fell from 1.5% at the end of last year to 1.3% at the end of May 2013, and is expected to remain below 2% for the next 12 months.
“And while low liquidity remains a key risk for high-yield bonds, current liquidity is healthy.”
High yield is more sensitive to the business outlook than traditional fixed income. However, Alain Desbiens, a vice-president with BMO ETFs, says high yield is still well positioned in a potential rising rate environment. “High yield is more credit sensitive, and less rate sensitive,” he says.
Paul Tepsich agrees. The president and CEO of High Rock Capital Management Inc. says there’s no real risk of the high-yield market witnessing any idiosyncratic fall, independent of other asset classes like equities. Despite record outflows in high yield in May and June 2013 due to rising rates, he says high yield represents credit risk, not interest-rate risk.
“High yield has zero correlation to interest rates. Rates rise because the economy is doing better. That creates excess cash flow, which in turn covers our coupons more. That’s a good thing.”
The May/June rate rise, Tepsich adds, was too much, too fast. “It affected not only high yield, but pretty much every asset class negatively. Stocks plummeted almost 5% in a day and a half. Future rate rises are likely to be much more gradual, and we’ll see high-yield bonds hold well. Any rate rise will be absorbed through spread compression, as we’ve seen in the past.”
In light of an aging demographic, Tepsich also doesn’t see a sustained rotation out of high yield in favour of equities. “[Older] investors cannot assume the same volatility they did 15 years ago.”
Respectable returns
Since the credit crisis, corporate debt has outperformed government debt. But Tepsich says the easy money has already been made in the high-yield market. “Last year saw returns in the 12% to 15% range. This year will likely be what we call a good coupon year—6% to 8% returns. But eventually we’re headed for sustained low volatility and 4% to 5% spreads to treasury bonds—similar to what we saw from 2004 to 2007.”
Tepsich bases his hunch on macro credit fundamentals:
- Leverage is about average.
- Issuers’ abilities to pay coupon interest are near record highs.
- Cash versus short-term debt. is still high, which means lower refinance risk.
- Issuers have termed out a ton of bank and bond debt, further lowering refinance risk.
Utomo’s firm offers a similar outlook. “While total returns this year will likely fall short of the extraordinarily strong performance in 2012,” she says, “we still expect attractive total returns of 3% to 4% over the next six months [as of July 2013].”
Asset allocation
Desbiens says high yield should be treated only as a satellite holding. “It should comprise no more than 5% to 10% of a portfolio.”
Utomo is more comfortable with 5%. But that doesn’t cut it for Tepsich. “People need to understand high yield is an asset class just like equities or government bonds. You’re not going to get the benefits of risk-return metrics unless you have a decent weight,” he says.
For a regular diversified portfolio, Tepsich allocates as much as 25% in high yield, 50% in equities, 10% to 15% in government bonds, and a smattering of real estate or other such assets. In his personal portfolio, he holds about 35% high yield.
Tepsich also recommends high-yield bonds for the 60-plus demographic. “High yield outperforms equities on a risk-adjusted basis over almost any period. Never has that been more important.”
Most seniors, he says, would choose a Canadian bank stock over a well-diversified portfolio of high- yield bonds. “But that’s the wrong decision. Over the past five years, the Canadian bank index has shown annual returns of about 8.5% but with an astounding annual standard deviation [volatility] of 22%. Canadian high yield, on the other hand, has shown 5-year annual returns of 14.1%, with an 8% standard deviation,” Tepsich adds.
Baiting alpha and beta
The best ways to buy high-yield bonds are through ETFs, mutual funds and pooled funds, such as closed-end funds.
“Mixing beta and alpha is another good way to access this asset class,” Desbiens says. During periods of market uncertainty, high-yield bonds can be much closer to equity than fixed income.
“That’s when access to the entire market—through ETFs—helps avoid the pitfalls of picking individual securities. Add to that a good alpha manager, and you get a team that specializes in managing credit risk assets, reviewing individual issuers and selecting based on market conditions,” he adds.
Tepsich says retail investors are best served buying a well-diversified portfolio through a retail fund that specializes in high yield. It’s best to leave individual issuers to the discretion of experienced portfolio managers because:
- Individual picks provide little by way of diversification;
- Investment advisors do not get very good pricing on secondary trades; and
- Each bond is backed by an indenture, which can run up to 250 pages.
Good, bad, ugly
The good investments in high yield, Tepsich says, are backed by strong indentures, which include covenants that protect the buyer.
High-yield covenants can protect bondholders from detrimental actions by equity owners, preserve a bond’s claim priority, and accelerate restructuring to distribute value to creditors.
Bonds with more senior claims historically have higher recovery rates in the event of default. A bond with guarantees from the issuer’s operating subsidiaries receives credit support from them, as well as the holding company. Bondholders should be closest to the subsidiaries in the event of default, as that’s where the assets sit, Tepsich says.
Certain covenants, including the limitation on indebtedness and liens tests further define the bond’s place in the capital structure and protect it going forward. According to Tepsich, well-chosen high-yield bonds place investors near the top of the capital structure.
“With equities, you get all the upside during good times, all the downside during bad times. With bonds, the recovery is much higher if things go south.”
When considering high-yield debt, Desbiens says investors should consider the business cycle and overall outlook of a corporation. “This asset class is more sensitive to business outlook than traditional fixed income. The lowest quality high yield will be the most sensitive, so diversifying investments by sector and issuer in that asset class is really important.”
Utomo cautions against highly illiquid debt. She’s also wary of debt that doesn’t have any analyst coverage. It usually comes with higher risk. In light of eventually rising interest rates, she also recommends avoiding long-term bonds, and focusing on short- and medium-term maturities.
Also watch for deteriorating credit. Telltale signs include: a fall in ratings; analysts downgrading a company; a drop in sales; over-leverage, or a lower interest coverage ratio (the higher the ratio, the better the state of the balance sheet). When assessing issuers, Tepsich takes top-down and
bottom-up approaches.
Top-down analysis:
- Federal policy: the things governments or central banks may do to alter markets.
- Macro credit fundamentals: leverage in the high-yield system; what a high-yield issuer looks like on a leverage basis or an interest coverage basis; etc.
- U.S. money lender banks: are they holding cash, buying government bonds, or are they starting to lend into the real estate market, and commercial and industrial loans?
- Themes within sectors: are we bullish on oil, gold, natural gas or consumer? This analysis helps with individual picks.
Bottom-up analysis:
Research each portfolio’s spreadsheet. Some companies have complicated organizational charts. Identify which entity issued the bonds, and the protections or covenants. Monitor quarterly results for revenue and profitability.
High-yield bonanza
The recent recession resurrected non-investment grade corporate bonds as higher-yield investment options for portfolio managers.
Interestingly, most issuers over the past four years or so seem to have returned to the market to refinance old debt at lower rates. Paul Tepsich, president and CEO of High Rock Capital Management Inc., says this terming out of shorter-term bank debt by issuing five-to-seven-year bond debt helps secure future financing and creates optionality, especially for equity.
In fact, two-thirds of the high-yield bonds issued this year have been used to refinance existing debt, says Phaby Utomo, executive director and senior private wealth manager, UBS Wealth Management. “Besides, smaller and growing companies are more inclined to issue debt as opposed to stock because such a low-interest environment makes it cheap to issue debt.”
Abundant liquidity also makes it viable. “Issuing stock means these companies dilute their ownership,” Utomo says. “Stock issuance perhaps isn’t such a viable option for non-blue-chip companies. Their risk profile is different from mega companies that may have an easier time raising equity.”
Kanupriya Vashisht is a Toronto-based financial writer.