HighYield as a Store of Value

Have we seen a paradigm shift in the role of high yield bonds in an asset allocation? The asset class[1],once thought of as a narrow investment category where investors got paid to wait as business cycles shifted, has demonstrated noteworthy performance and volatility attributes during the past two decades. Over time, high yield bonds’ relatively high coupons, muted interest rate sensitivity and performance have contributed to their role as a store of value, particularly at certain points in the economic cycle (see table above).

 

For the past two decades, high yield bonds and their yield advantage have benefited in an environment of declining interest rates while generating volatility statistics that compared favorably with the S&P 500 Index. The chart on the left below compares the cumulative annual return of the Barclays Capital US High Yield Index versus that of the S&P 500 Index from January 1990 through September 2010, while the chart on the right compares these indices’ rolling 12-month standard deviations for the same period. The combined view of historical return and risk appears attractive.

 

HighYield in a Challenging Income Environment

In addition to the competitive risk and return characteristics generated over the past 20 years, the high yield asset class, in our opinion, also appears attractive in the context of today’s market characteristics. The “hangover” from the financial crisis and subsequent quantitative easing by the major central banks have driven high-quality nominal bond yields around the world to extremely low levels. Baby boomers, with potentially long retirements ahead of them, are likely going to be faced with replacing earnings in a challenging yield environment. The need for a steady income stream could be acute for many boomers. The income from a $1 million portfolio of 10-year Treasury bonds yielding 4.5% before the 2007/2008 financial crisis would have been $45,000[2].At the end of September 2010, a new $1 million portfolio would have yielded approximately 2.5% and generated only $25,000 of income.

 

 

Many investors are looking for answers; therefore it shouldn’t be surprising that income-producing assets, such as high yield and dividend paying stocks, have been seeing steady performance gains and fund inflows.

Our contention is that high yield bonds are likely to continue to be a respectable store of value. We base this on their valuation profile and fixed income characteristics, which tend to stand out in the midst of a protracted economic recovery and ongoing deleveraging process that could have significant implications for economic growth and yield potential.

 

Coupons & Dividends: Potential Performance Buffers

Market pundits sometimes call high yield “equity light,” or “stocks with coupons.” In the post-crisis environment, where economic growth as well as yield are in short supply, sources of income have been crucial to performance. For example, during periods of low nominal returns, like the market experienced in the past decade for stocks[3], the S&P 500 Index cumulative return with dividends reinvested was -4.22% while the Index’s return calculated without dividends reinvested was -20.56%.

 

Reinvested dividends were a key factor in the S&P’s cumulative performance. During the same period, high yield bonds did better than the S&P 500, in part because coupon income was a large component of high yield returns. In an environment of low nominal growth and income, high yield coupon income can be a welcome contribution to performance.

 

Clipping Coupons In a SlowRecovery

The market is likely weathering one of the longest economic recovery periods in American history. The post-financial-crisis debt “hangover” could be long and drawn out, as explained by economists Kenneth Rogoff and Carmen Reinhart in This Time is Different: Eight Centuries of Financial Folly (2009, Princeton University Press). In their study, the authors highlighted the major consequences of a financial crisis: GDP per capita growth can be a full 1% lower in the 10 years after a crisis compared to prior growth levels, the unemployment rate can remain stubbornly high and deleveraging trends can persist for a decade or more. The sub-par recovery underway in the US economy appears to be playing out as they predicted.

 

 

The table above breaks down the economic cycle into three phases: contraction, recovery and stable. High yield and convertible bonds performed well relative to other asset classes in what we defined as recovery periods, but they also performed well in stable conditions. The last column of the table is the current recovery phase, and the solid performance of convertible and high yield bonds has remained intact. Remembering that Rogoff and Reinhart warned that this could be one of the longest recovery periods in American history, holding high yield bonds in a portfolio may be worth considering.

 

In a deleveraging cycle, as the private and public sectors reduce the amount of debt on their balance sheets, interest rates usually drop to very low levels because central banks use monetary policy to help offset weak demand. Equity markets typically rally once corporate balance sheet restructurings start to raise the return on capital. Until then, high coupon income during the recovery phase of the cycle can be a stable contribution to portfolio performance in a low yield environment.

 

 

Balance Sheet Repair

Corporate balance sheets in the US are undergoing repair, and during this process, bonds are typically favored relative to equities. From September 2007 to June 2010, there was a 20% drop in tangible assets[4]on the balance sheets of the non-financial corporate sector and a 9% rise in liabilities, as shown in the chart at right. This may suggest that companies still need to continue deleveraging and raising their level of savings.

The process of deleveraging implicitly assumes the need for companies to raise equity and/or reduce debt to get leverage ratios back in line after a hit to asset values. This transition could be supportive of high yield company fundamentals.

 

The private sector in aggregate (businesses and consumers) appears to be working aggressively to raise its level of savings and build in a cash and liquidity buffer on its balance sheet. Private sector savings, close to 7% of GDP, is near the record high. In our view, this should help raise the credit quality and reduce the risk premium on private sector assets.

 

 

HighYield and Defaults: In the “Sweet Spot” of the Cycle

High yield performance has historically been intimately tied to default rates. Rising default rates can be a late-cycle phenomenon. Historically, characteristics of late stages in a cycle have included easy underwriting standards, free flowing bank credit, booming merger and acquisition (M&A) activity, billion-dollar private equity funds being leveraged, stock buybacks, covenant-light debt deals and more corporate leverage. The period from 2005 through 2007 was such an interval. Then, as the late-cycle boom turned to bust, high yield bond prices came under severe pressure, and default rates began to escalate in late 2009.

 

A recession and spike in defaults typically takes weaker high yield credits from the market, leaving stronger and better capitalized companies that can help sustain high yield performance. After a recession, companies are generally keen on reducing the risk of default by taking actions including reducing leverage, raising liquidity and fixing their balance sheets.

 

With high yield spreads tightening and default rates declining in 2010, as indicated in the chart to the left, the market appears to be in the early stages of a new economic cycle—sometimes referred to in the market as the “sweet spot” of the credit cycle.

 

We believe the high yield bond market is likely to remain in the “sweet spot” for some time as companies deleverage, corporate savings remain very high and money and credit growth are extremely subdued.

 

The high yield market has grown in 2010 as strong investor demand has allowed many companies to refinance and extend their debt maturities. With the high yield market open for business, there is a risk that underwriting standards could get easier and credit quality could start to deteriorate; however, the market does not appear to be near the level of M&A or leveraged buyout activity that has typically signaled deterioration of investment discipline commonly seen late in a cycle.

 

HighYield Valuation: Spreads Still Wide Relative to Default Expectations

High yield spreads remain elevated while default rates have plunged in 2010, as shown in the previous chart. At the end of September, Fitch Ratings reported the trailing 12-month default rate was 3.5% and estimated the average default rate would be approximately 1% by the end of 2010. This level of defaults is notable considering high yield spreads-to-Treasurys peaked at more than 20% in December 2008. The weighted-average recovery rate has also risen dramatically, and according to Fitch, was 54% of par at the end of September 2010.

 

 

We are able to estimate a measure of high yield valuation by viewing spreads as a simple function of default rates and recovery rates. We can solve for the implied default rate if we have the level of high yield spreads versus Treasury yields, the recovery rate and an implied excess return assumption[5]. We generated the data in the matrix at right using an excess return assumption of 250 basis points, which is the 20-year average excess return of high yield bonds based on the Barclays Capital US High Yield Index versus Treasury yields (as of September 30, 2010).

 

With spreads greater than 2000 basis points in December 2008, the simplified valuation matrix above would suggest default rates greater than 20% and recovery rates less than 30%.

 

Plugging in an estimated 2010 default rate of 1% and the weighted-average recovery rate of 54% would suggest a high yield spread between 295 - 300 basis points. That is significantly lower than the 621 basis point spread as of September 30[6].  We are not suggesting that high yield spreads will go to the 295 - 300 basis point range in the near-term, even though spreads did approximate those levels in 2007. The point we wish to make is that based on our calculations, it appears good value remains in the high yield asset class. Its excess spread could potentially help compensate for a rise in default rates, a drop in recovery rates or a rise in Treasury yields.

 

Focusing on Real Yields

Real yield is another valuation metric for high yield bonds. Nominal interest rates are at very low levels, particularly 10-year Treasury yields below 3.0% at the end of September. However, we do not believe nominal yields relative to history are an appropriate valuation metric. Real yields may be more relevant because they adjust for inflation.

 

Based on the inflation rate of 0.8%[7] and the yield for the Barclays Capital US High Yield Index of 7.8% at the end of September 2010, the asset class offered a real yield of 7.0%, which is relatively high and more than one and a half times the 4.0% real yield hit in 2004 and 2005. We are currently experiencing a sputtering economic recovery and the Federal Reserve has announced another round of quantitative easing. The portfolio balance theory that lies at the core of quantitative easing would suggest that real yields need to drop across the credit spectrum to achieve a sustainable expansion in the US economy[8]. By the end of September, quantitative easing had already driven the level of real yields on 10-year Treasury Inflation Protected Securities (TIPS) to 0.40%.

 

Investment Summary

There is potential for investors to benefit from broadening their perception of high yield bonds and the asset’s role in an allocation. In our view, these securities should not be thought of as only a tactical position where investors get “paid to wait” before making an allocation to alternative assets such as equities or hedge funds. We have seen that historically high yield investments can be a good store of value over time and we believe that pattern could continue.

 

The properties of high yield bonds could make them worthy of consideration given the current low level of defaults and rising recovery rates. Their 7.8%[9] yield is notable in this low-return environment, as is their place in the capital structure, relatively favorable coupons and fixed income characteristics.

 

Call-out

 

 

[1] As represented by the Barclays Capital US High Yield Index

[2] This hypothetical scenario is based on Bloomberg data and assumes bonds are held to maturity. Income is before taxes and fees. This is for illustrative purposes only, your results will be different. Past performance is no guarantee of future results.

[3] Source: Bloomberg, ten years ending September 30, 2010

[4]  Tangible assets have a physical existence, such as cash, equipment and real estate; accounts receivable are usually considered tangible assets for accounting purposes.

[5] The specific equation is: Yield Spread - Default Rate x (1 - Recovery Rate) = Excess Return

[6] Spread is for the Barclays Capital US High Yield Index relative to Treasurys

[7] Year-over-year September Core CPI

[8] Deflation Economics: Quantitative Easing and Portfolio Balance Channel, October 2010 Loomis Sayles white paper

[9] Barclays Capital US High Yield Index as of September 2010

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