High yield: high risk?

Christopher Andrews finds that now is the time for pension schemes to pick up some well-valued ‘junk’ bonds, without having to fear that their assets will disappear

When Michael Milken, father of the high yield debt market, went to prison for securities fraud in 1989, it was not surprising that the so called 'junk bonds' he left in his wake became perceived as incredibly risky and likely never to pay off. However, times have changed and there is now little similarity between the results of Milkin's unfettered greed and the modern, arguably conservative, high yield market.

Bond price collapse
That market is currently worth around $1 trillion, with the vast majority of issuance, in the realm of 90 per cent, coming out of the US. The bonds themselves are corporate issues rated below investment grade, or lower than BBB- by Standard & Poor's and Fitch, or Baa3 by Moody's.

And it is very interesting times for high yield at present. The past 18 months have been "awful" according to Adam Cordery, high yield manager at Schroders, with bond prices collapsing under the threat of impending recession. "It's a very volatile asset class and it tends to be very pro-cyclical. So in times like this when economies are turning down then high yield performs very poorly."

In fact, according to the Merrill Lynch Global High Yield Index, year to date the market is down over 24 per cent, which according to Todd Youngberg, global head of high yield at Aviva, is by far the worst year there has ever been for this asset class. "Going back 20 plus years, basically the Michael Milken days since he created the market, the worst year in high yield was only down five or six per cent depending on the index."

Meanwhile, spreads on high yield bonds are now at historic wides, and by a considerable margin. "Over the last 20 years we have seen three different peaks in spreads," says Youngberg. "In 1990 when spreads hit 1,100 over and then compressed significantly. In 2002 spreads widened out again to almost the same level by 1,000 over and then significantly contracted back in. And right now we have spreads at almost 1,600 over – all time wides by far."

Also, oddly given the current market conditions, default rates are experiencing historic lows, presently around 2.8 per cent year to date according to Moody's. And as Andrew Wilmont, fund manager on AXA IM's UK fixed income team, points out: "Arguably you could say investment grade defaults are a lot higher than in high yields at the moment." This is because a majority of the high yield indices are comprised of industrials, with a very small percentage – around five per cent – made up of financials. This compares to around 50 per cent financials within investment grade.

However, those default rates are not expected to remain as they are. "Assuming there's going to be recession," says Wilmont, "we do expect default rates to increase." Moody's, in fact, has predicted that in the next year they expect an increase to around eight per cent.

A matter of timing
So with the market having suffered for the past 18 months, and the number of defaults set to increase significantly in the next year, why would any pension scheme consider getting involved with this asset class now? Well namely because in addition to picking the right mix of bonds, high yield investment is a matter of timing; and the timing is starting to look good.

Chetan Ghosh, investment strategist at Investment Solutions, says we are currently at a finely poised stage. "So you're going to get to a time when there's an inflexion point, and the yields start to fall because we get into a period of greater economic stability, and as the yields fall you'll get a capital appreciation. We're not there yet, but you don't want to miss the time when there's that inflexion point."

"Bizarrely in three years when high yield has recovered and everyone is looking to get involved, that will probably be the worst time as the value will have gone," says Schroders' Cordery. "So if you were going to do it at any point in the cycle now is when you should start thinking about how you are going to. I'm not saying you do it necessarily, but try and figure out a strategy for doing it and picking the right bonds."

With high yield now so cheap, when markets improve there will be a potentially hefty capital upside, as mentioned by Ghosh, with the yields currently available producing solid income in the interim.

And with yields at their current rates, default risks are also less of an issue. As Aviva's Youngberg points out: "Today the market has a yield of over 18.5 per cent and a current coupon yield of about 12.5 per cent. That yield can cushion a lot of the price volatility that would be caused either by further spread widening or rising defaults. So if default rates went up to 15 per cent over the next year, your returns would only be down about three per cent.

"If you can get involved in the market when the income component is at an all time high, that is a terrific entry point even when default rates are going up. We've done the math.

"The defaults are yet to come out of the woodwork," says Ghosh. "And the question is, is the level of defaults that the market is pricing in above or below what's going to happen."

Wendy Nickerson, portfolio manager at Muzinich, says that her company is currently pricing in for a 15 to 18 per cent default rate, considerably higher than either the Moody's prediction, or the historical peak of 10.5 per cent. "So I would argue there is a value proposition where you have more than enough bad news priced in, unlike equities or emerging markets," she says.

"And we have 14 or 15 per cent yield on our portfolios, so you're collecting a big yield just waiting for the market to improve, which is totally different from equities where you're looking at price appreciation or depreciation. So you have a high income stream and a short duration to realise that."

Of course high yield managers are ideally trying to limit the number of companies in their portfolios which do default, making it very much a "stock pickers world" according to Cordery.

And in many ways this is quite straightforward, he says. "You do a traditional credit analysis and figure out if a company has enough asset value and cash flows to survive a recession. This is a traditional bank analysis that good credit officers at banks have been doing for hundreds of years."

Risk perceptions
That being said, for many, high yield hasn't escaped the tarnish of the eighties, and mis-perception or not, is still seen as a risky proposition. "To me high yield is much less risky than emerging markets [for example] but it seems like a lot of institutional investors are very comfortable with emerging market risk," says Muzinich's Nickerson. "That doesn't make sense to me. Our companies are transparent, we know they don't have funding needs. I suppose it is because the market really started developing in the mid 1980s, so it hasn't been around that long."

In addition, the market used to be considerably smaller, so portfolio diversification was an issue. This, says Nickerson, has changed with development in terms of the mix of companies and industries in the indices. "So I think people are still looking at it through a lens of 20 or 25 years ago, and the market has come a long way."

- Pensions Age November 2008