High-yield bond owners have endured higher than normal volatility and the threat of rising interest rates. But, to understand what’s next, we first need to look to history.
The last Predators’ Ball
Country music legend Kenny Rogers headlined the 1987 Predators’ Ball, an event held by the now-infamous investment bank Drexel Burnham Lambert. But, because that type of music isn’t my thing, I left after dinner and missed the singer’s famous rendition of “The Gambler.” The corporate raiders in attendance, who were leveraging America’s balance sheets using below investment-grade (junk) bonds to buy companies and sell off the pieces, would have done well to heed the song’s prescient lyric, “…know when to hold ’em. Know when to fold ’em.” Within months, a liquidity event and changing tax laws would mark the beginning of the end for Drexel’s high-yield desk, its leader Michael Milken, and an era. Today, low interest rates and high equity valuations make high-yield bonds attractive to people who remember the 1980s.
Milken’s research showed historical default rates for junk bonds—those rated “BB” or lower by S&P (now SPDJ), or “Ba” or lower by Moody’s—were low relative to the incremental yield offered, meaning junk bonds were undervalued. Institutional investors saw a windfall in returns for modestly higher risk, so the popularity of junk bonds flourished during the 1980s.
Investors viewed companies with cash flow available to support high-yield debt financings as more valuable as than those with strong traditional measures of earnings and book value. So, corporate executives nervously revisited business efficiencies lest a raider mount a leveraged buyout, fire management and make changes.
Capital efficiency improved in the aftermath, and shareholders benefited. But the permanent cost of hostile acquisitions has been a focus on short-term results, at the expense of building long-term value—think shipbuilding and Morse Industries from the movie Pretty Woman, where Richard Gere’s character initially wants to dismantle a 40-year-old firm and sell its components for profit.
Factoring default risk
Investors don’t buy high-yield bonds to be altruistic. They want more yield and are willing to take some risk to get it. Still, the sell-off in high-yield bonds (e.g., the -8.9% return for US Markit iBoxx High Yield Total Return Index) in the second half of 2014, showed there are limits to the risks investors will assume. High-yield interest spreads over 5-year U.S. Treasuries expanded as oil prices declined. The energy company debt that constitutes about 15% of the U.S. high-yield market was expected to be under pressure. The market has since adjusted and the estimated default rates for the high-yield sector, which have averaged 3.8% historically, are expected to be a relatively modest 1.5% to 2.0% in 2015, according to Fitch Ratings. Despite a slow start in 2015, U.S. economic growth has persisted, providing high-yield bonds with a solid platform. But are they good value? Investors expect a 3% premium over U.S. Treasuries and a premium for possible defaults on top. Assuming default recovery is 35% (bond holders lose 65% of their investment), an implied risk premium would be 3% plus 65% of the expected default rate (0.65 x 2.0% = 1.3%), or 4.3%.
As of April 2015, the BMO High Yield Corporate Bond ETF (ZHY) has a yield to maturity of 6.2%, compared with 5-year U.S. Treasuries at 1.34%. A spread of 4.66% suggests that high-yield bonds are fairly valued to modestly attractive.
While missed interest payments and downgrades are also risks, defaults are worse. The ETFs listed in the table below are based on U.S. high-yield bonds, where the depth of the market allows for better diversification. The number of holdings and the balance between credits is important. The two actively managed ETFs, Powershares (PFH) and Horizons (HYI), sport higher credit quality and fewer holdings than the others.
The U.S. high-yield market distinguishes between original-issue and fallen-angel (the latter describes companies with investment-grade credit ratings that have since declined). Because some institutions are forced to sell credits that fall below minimum standards, these fallen angels may offer better relative value when compared to original-issue below-investment-grade paper.
There aren’t any Canadian-traded fallen-angel high-yield ETFs available. But the Market Vectors Fallen Angel High Yield Bond (ANGL), which seeks to replicate the performance of the BofA Merrill Lynch US Fallen Angel High Yield Index, is one that has performed relatively well.
Rising interest rates
Expectations of higher interest rates nag investment managers and asset allocators. High-yield bondholders may accept changes in market value due to rising rates to get the higher payouts, but advisors must find the balance between more income and capital protection. Strategically, reducing duration (to zero) is the best approach to protect fixed-income assets when rates rise. The introduction of senior-loan and short-term high-yield ETFs offer tools to address these problems. With global mergers and acquisitions at a post-crash high, the corporate raiders of 1987 would feel right at home.
|Canadian-traded high-yield bond etfs (bold) and benchmarks (italic)|
|Symbol||Duration (years)||Dist. Yield||YTM||Mgt. Fee||Holdings (#)||Credit Quality (%)|
|BMO High Yield US Corporate Bond Barclays Capital US High Yield Very Liquid Index CAD||ZHY||4.13||5.94%||6.20%||0.55%||536||BB 37.3 B 46.0 C 16.7|
|iShares US High Yield Bond Markit iBoxx US Liquid High Yield Total Return Index CAD||XHY||3.96||5.58%||6.02%||0.62%||879||BB 46.1 B 41.0 C or less 12.9|
|iShares US High Fixed Income Barclays Capital US High Yield Very Liquid Index CAD||CHB||4.05||6.72%||5.82%||0.55%||480||BB 39.5 B 44.4 C or less 16.1|
|Powershares Fundamental HY Corporate Bond RAFI Bonds US High Yield 1-10 CAD||PFH||3.86||5.83%||4.68%||0.65%||290||BBB 14.7 BB 55.2 B 27.3 C or less 2.8|
|Horizons Active High Yield Bond No benchmark||HYI||4.22||6.15%||5.62%||0.60%||130||BBB or + 14.2 BB 37.1 B 41.0 C or less 7.2|
Originally published in Advisor's Edge Report
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