The search for yield has become increasingly challenging in today’s market—one dominated by fear and uncertainty—but investors can make hay with high-yield bonds.
With spreads over Treasuries near historically wide levels, defaults near record lows and many companies flush with cash and showing clean balance sheets, the high-yield market is poised to continue to outperform, says Doug Forsyth, portfolio manager of the Allianz AGIC High Yield Bond Fund. When compared to higher-quality bonds, high-yield bonds have lower interest rate volatility and higher income potential, he says.
Breaking down the numbers, the yield-to-maturity for the high-yield market currently stands at 8.5% and the Merrill Lynch High Yield Master II Index is up an annualized 25% spanning the period from Dec. 31, 2008 to Oct. 31, 2011. Meanwhile, new issuance totaled $217.2 billion year-to-date through the end of October.
Forsyth, a 19-year veteran in investment management with an acute focus on high-yield bonds, along with portfolio manager William Stickney, have a consistent long-term track record relative to their peers. The fund seeks equity-like returns with bond-like volatility while benefiting from the steady income from the bond coupon. Their bottom-up credit research and total return approach leads them to invest in companies that are poised for sustainable growth based on strong balance sheets, prudent cost controls and good revenue visibility. To their credit, there hasn’t been a single default in the portfolio in the last 10 years.
With faith in financial markets visibly shaken, investors run the risk of veering off course from their financial goals by sitting in cash or zero-coupon bonds. High-yield offers them a measured way to stay committed to such goals without taking on unnecessary risk. For more color on the case for the asset class, the team’s philosophy and how they take advantage of ratings inefficiencies, read on.
Why are high-yield bonds particularly attractive in the current environment?
Forsyth: Today’s wide spreads—over 700 basis points—give the high-yield sector a significant yield advantage—not just over Treasuries, but over other bonds as well. Macro events have driven price volatility higher and spreads wider. The market is anticipating much higher default rates than are actually likely—both now and in the near future. The current default rate is near record-lows at 1.58% through the end of October as compared to a historical average of 3% to 4%. We don’t see defaults going above 6% in the next 12 to 18 months, even if we go into a recession.
Corporate balance sheets are very healthy—unlike 2008—with companies carrying high levels of cash on their books. Companies have refinanced much of their debt, so their debt service costs are much lower. The result has been greater liquidity and low leverage in the system, leading to upward operating performance and, again, a lower risk of defaults. We are seeing a positive upgrade trend with upgrades exceeding downgrades at a near-record pace. This is a testament to the health of issuers’ earnings and balance sheets.
How does the integrity of corporate balance sheets today measure up historically?
Forsyth: It is perhaps most comparable to the mid-'90s and mid-2000s, when defaults were exceptionally low, the economy was recovering, high-yield issuers were refinanced at lower levels and you saw a lot of upgrades.
What’s your take on market volatility right now?
Forsyth: From a credit risk perspective, in the 17 years that I've spent at AGIC managing assets, individual country risk in Europe has never been a concern. The same holds true for political risk in the U.S. Simply put, we can’t control the market; we can only control the companies we own. We conduct bottom-up research and follow the fundamentals to help us buy the best companies because success in this asset class rests on the ability to choose the correct issues.
In terms of your investment philosophy, what do you look for in a high-yield investment?
Forsyth: We follow a disciplined, bottom-up research process to build a portfolio of high-yield corporate issuers that demonstrate improving fundamentals. We take an equity-like approach in that we’re always looking forward—as opposed to looking at trailing cash flows —at ways companies can grow and strengthen their credit profile. Specifically, we’re looking for companies with the ability to beat earnings expectations, the potential for bond rating upgrades, debt reduction and capital-raising capabilities and the potential to be recognized as an acquisition candidate. We believe these companies are poised to outperform.
What triggers or red flags do you look for to prompt selling out of a position?
Forsyth: We employ a series of sell alerts that trigger further research such as a change in credit fundamentals, a decline in relative attractiveness to other issues and a decline in industry fundamentals. We monitor them closely. We’ll sell a security if the rationale for purchasing it no longer holds true. One example is a company that misses earnings expectations. But fundamental change is not the only driver. If the spread has contracted to a point where it’s no longer offering relative value, we need to sell it. New candidates continually challenge current holdings, thereby making it imperative that each holding continues to earn its place in the portfolio.
How do you exploit inefficiencies in published credit ratings using your proprietary Upgrade Alert Model?
Forsyth: We find that most companies—roughly 80%—are misrated based on the ratings agencies’ own standards. We look to identify companies that should be rated differently based on those standards. Oftentimes, there is a better operational direction that has enabled companies to cut costs and generate higher earnings and operating income. Combine this with our fundamental research—which helps us spot balance sheets that are better than the ratings suggest—and you arrive at a list of companies that are well positioned to perform. We believe that every name in the portfolio is a potential upgrade candidate.
What fundamental changes have you seen in the high-yield bond market over the last 10 years that might benefit investors?
Forsyth: The investible universe has broadened in terms of industry exposure. In the past, there were periods of high concentration. Today, however, we see a well-diversified universe. An investment in high-yield bonds can actually help diversify rather than concentrate the bond position of a portfolio, which helps moderate overall risk.
Why do high-yield bonds make sense as a long-term investment?
Forsyth: Over time, high-yield bonds have had a favorable risk/reward profile relative to other asset classes, providing equity-like returns with less volatility. In addition to higher coupons than other asset classes, high-yield bonds also offer capital appreciation potential. Investors’ ongoing need for income is likely to lead to increased buying of high-yield bonds, which could drive prices up.
How will they fare in a rising interest rate environment?
Forsyth: High-yield bonds have historically been less sensitive to interest-rate swings than Treasuries or high-grade corporate debt because their prices are more closely linked to the credit quality of individual issuers. Among fixed-income alternatives, high-yield bonds will be a contributor from both a diversification and relative performance perspective.
What is your overall outlook for high-yield bonds going forward?
Forsyth: Our outlook for the high-yield market is positive based on clear trends in credit statistics. Defaults are low and will likely stay low for an extended period. Upgrades have exceeded downgrades at a pace that challenges the best on record. Spread contraction going forward will likely be generated by a combination of rising interest rates and price appreciation. When we look at that in correlation with cash, the leverage ratios on the balance sheet are as good as they’ve been in the last 25 years. Half of the high-yield market has refinanced in the last two-and-a-half years, eliminating maturity risk. All of these factors contribute to our outlook that defaults will remain low.
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