Introduction: From the Eurozone’s sovereign debt crisis to the United States’ uncooperative Congress, raging geopolitical uncertainty continues to give investors pause. In addition to precipitating undue stress, uncertainty can also precipitate opportunity. The combination of high yields and low defaults is quite uncommon, and in our opinion, presents an unusual opportunity for the astute investor.
Fundamentals in the high yield market are strong, valuations are compelling, and technicals reasonable. This is a tasty recipe for high yield investors and we are optimistic about the market’s prospects—this newsletter will highlight our top 10 reasons to invest in high yield in 2012.
#1 Risk/Reward Profile
Chart 1 shows a variation of a risk/return profile using historical volatility on the X-axis and yield on the Y-axis. Volatility can vary over time so using historical standard deviation is not perfect, but it helps provide some context about how various asset classes have behaved in the past. The Y-axis plots the current yield for fixed income asset classes and dividend yield for equity asset classes. This is also imperfect because coupon and dividend payments are not assured, but again it helps provide some perspective. As depicted in the chart, high yield has exhibited more volatility than investment grade fixed income and less volatility than equities; it exhibits a higher yield than any of the other major asset classes shown.
#2 Effective Complement
Because high yield exhibits limited correlation with other major asset classes, it tends to improve the risk/return profile of typical portfolios. On Chart 2, the light green line represents the efficient frontier of a portfolio composed of two basic asset classes: equities and core fixed income1. The lowermost/leftmost point on this line represents 100% core fixed income and 0% equity. As you move to the right, the percentage of equity increases until the uppermost/rightmost point on the line, which represents 0% core fixed income and 100% equity.
The dark green line shows the same portfolio but adds a 20% allocation to high yield bonds2. The leftmost/lowermost point on the dark green line represents 20% high yield and 80% core fixed income. As you move to the right, the percentage of equity increases and the percentage of core fixed income decreases, but the percentage of high yield remains 20% throughout. The rightmost/uppermost point on the dark green line represents 20% high yield and 80% equity.
As shown in the chart, adding a 20% allocation to high yield would have enabled an investor in a basic core fixed income/equity portfolio to either increase their return for the same level of risk, or decrease their risk for the same level of return over this 25 year period.
#3 Spreads Relative to the Default Rate
As the number of defaults in the market increases, intuition tells us that investors should demand a higher yield to compensate them for increased risk. Empirical evidence supports this claim, as the correlation between high yield spreads and the high yield default rate is positive 0.56 over the past 25 years. The reason that the correlation is not closer to 1.0 is because the default rate is a backward-looking metric focused on actual defaults and the spread over Treasuries is a forward-looking metric reflecting the market’s sentiment about the future. When spreads exceed the default rate by a wide margin, as shown in Chart 3, the implication is that the market believes the default rate is likely to increase going forward. If the default rate does not increase, or increases marginally, then the implication is that spreads are likely to contract—a positive development for high yield investors.
Because default rates are near all-time lows, we believe the default rate is likely to rise/revert to more “normal” levels. Current spreads, however, imply a default rate close to 10%--a level that we view as exceedingly pessimistic.
#4 Incremental Yield Pickup
High yield spreads over Treasuries are wide for two reasons: 1) the yield-to-worst (YTW) for the high yield market is high and 2) Treasury rates are low. From an investor's perspective, paltry Treasury rates might make alternative investments more appealing relative to Treasuries, but it says nothing about the attractiveness of investment alternatives in absolute terms. In other words, wide high yield spreads could simply indicate that high yield is the better of two bad options. Therefore, rather than show the yield difference between high yield bonds and Treasury bonds (i.e. "spreads"), Chart 4 shows the relationship between high yield bonds and investment grade corporate bonds3. As highlighted in Chart 4, the YTW for high yield corporate bonds is normally 1.7x higher than the YTW for investment grade corporate bonds. As shown in Chart 4, however, it is 2.2x higher—nearly 30% higher than average.
#5 Wide Spread Distribution
Chart 5 highlights the distribution of spreads in the market. In May of 2007 (pre-financial crisis), spreads were not only narrow but were highly concentrated between 1-3%. In April of 2009 (the heart of the financial crisis), spreads were not only wide but were widely dispersed. We prefer markets composed of bonds offering a wide range of yields as opposed to a tight/clustered market. The former bestows vast opportunities for managers with distinct research advantages.
As illustrated in Chart 5, the market is more contracted than the extraordinary April 2009 market, but we believe it remains attractive for bottom-up credit researchers—opportunities abound.
#6 Annual Returns
Chart 6 depicts the calendar year returns for the BofA Merrill Lynch High Yield Master II Index since its inception—1987 was its first full calendar year. Only 5 of these 25 calendar year periods were negative. Until the -26% return in 2008, the worst calendar return had been -5% in 2000. Of course, past performance is no guarantee of future results. We have shown this to numerous investors, however, and most have been surprised that there have been so few negative years.
#7 Long-Term Returns
Chart 7 takes a longer-term view by highlighting the 10-year rolling returns for high yield, US equities, and international equities4. We do not claim that high yield is a stable asset class, but it has certainly been less volatile than equities. As depicted in Chart 7, high yield has never had a negative return over a ten year period—a claim that equities cannot make.
#8 Decrease in Leverage
Since the financial crisis, the market has undergone one of the largest and fastest financial deleveraging efforts in history. Managements have implemented aggressive cost-cutting programs, which has improved margins and created tremendous operating leverage. When these companies' revenues recovered, earnings and cash flows reached record levels. Many companies have used this cash to improve their balance sheets by paying down debt. Chart 8 shows the leverage for companies in the high yield market as defined by total debt to earnings before interest taxes depreciation and amortization ("EBITDA"). Leverage has declined considerably from the 2009 peak— companies appear to be in much better financial condition.
#9 Upgrade/Downgrade Ratio
Plummeting default rates and improved balance sheets has provided the rating agencies with reason for optimism. Consequently, upgrades have far exceeded downgrades recently, moving the upgrade/downgrade ratio near an all-time high. While this reflects the opinion of rating agencies, which have a less-than-stellar track record and whom we give little credence, it does further improve corporate health by reducing borrowing costs.
#10 Rising Interest Rate Environments
Chart 10 highlights five previous periods of rising interest rates since the inception of the BofA Merrill Lynch Master II High Yield Index. An increase in Treasury rates means a decrease in Treasury bond prices, but it does not necessarily mean a decrease in high yield bond prices. In fact, during each of these five previous rising rate periods the high yield market posted positive returns, ranging from +2% to +69%. To the surprise of many, the high yield market has actually performed better during periods of rising rates than it has during periods of falling rates. The table below shows the average annualized return of high yield bonds, investment grade bonds, and Treasuries in both rising (boxed in the Chart 10) and falling interest environments (non-boxed areas in Chart 10).
Contrary to investment grade bonds, high yield performance is primarily influenced by changes in the credit environment and economic growth rather than changes in interest rates. Most of the time, rising rates have coincided with economic growth—an environment normally conducive to high yield.
This is important because many prominent economists and investors believe an interest rate rise is inescapable. As depicted in the previous chart, interest rates have been in a secular decline for the past two and a half decades—a trend that many believe is likely to reverse.
Summary
Macroeconomic concerns in the marketplace are unnerving to say the least, but we believe these concerns have produced a compelling valuation opportunity for high yield investors. Spreads have blown out despite considerable improvement in fundamentals—most notable has been the strengthening of balance sheets. We believe defaults may pick up from record lows but should remain well below levels implied by current spreads. The ramifications of a disorderly European sovereign debt default and tighter liquidity in the high yield market remain threats, but we believe the attractive yields and strong fundamentals more-than-compensate for the risks at hand—and present a compelling case for investing in high yield in 2012.
Ray Kennedy and Mark Hudoff
Portfolio Managers
All investments contain risk and may lose value. Investing in the debt securities is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investment in lower-rated and non-rated securities presents a greater risk of loss to principal and interest than higher-rated securities.
Credit cycles vary in both length and volatility. Past credit cycles will differ from current or future cycles.
All references to high yield based on BofA Merrill Lynch US High Yield Master II Index. Investment grade bonds—Mortgage: BofAML US Mortgage Master Index. Corporate: BofAML US Corporate Master Index. Treasury: Barclays Capital US 10-Year Treasury Bellwether.
Data source(s): Chart 1: Morgan Stanley, Bloomberg, H&W. Charts 2-3, 5-7; Bloomberg, H&W. Chart 4: CreditSights, Bloomberg, H&W. Chart 8: JPMorgan, Capital IQ, H&W. Chart 9: JPMorgan, H&W. Chart 10: Barclays, Bloomberg, H&W.
1 S&P 500® Index and BofAML US Corporate, Government & Mortgage Index. 2 BofAML US High Yield Master II Index.
3 BofAML Master II Index and BofAML US Corporate Master Index. 4 BofAML Master II Index, S&P Index and MSCI EAFE Index. 5 High Yield: BofAML Master II Index. Investment Grade: BofAML Corp., Gov’t & Mtg Index. Treasuries: Barclays 10-Year Treasury.
©2012 Hotchkis & Wiley. All rights reserved. Any unauthorized use or disclosure is prohibited. This presentation is circulated for general information only, and does not have regard to the specific investment objectives, financial situation and particular needs of any specific person who may see this report. The research herein is for illustration purposes only. It is not intended to be, and should not be, relied on for investment advice.
Information obtained from independent sources is considered reliable, but H&W cannot guarantee its accuracy or completeness. The opinions expressed are subject to change and any forecasts made cannot be guaranteed. H&W has no obligation to provide revised opinions in the event of changed circumstances.
Fundamentals in the high yield market are strong, valuations are compelling, and technicals reasonable. This is a tasty recipe for high yield investors and we are optimistic about the market’s prospects—this newsletter will highlight our top 10 reasons to invest in high yield in 2012.
#1 Risk/Reward Profile
Chart 1 shows a variation of a risk/return profile using historical volatility on the X-axis and yield on the Y-axis. Volatility can vary over time so using historical standard deviation is not perfect, but it helps provide some context about how various asset classes have behaved in the past. The Y-axis plots the current yield for fixed income asset classes and dividend yield for equity asset classes. This is also imperfect because coupon and dividend payments are not assured, but again it helps provide some perspective. As depicted in the chart, high yield has exhibited more volatility than investment grade fixed income and less volatility than equities; it exhibits a higher yield than any of the other major asset classes shown.
#2 Effective Complement
Because high yield exhibits limited correlation with other major asset classes, it tends to improve the risk/return profile of typical portfolios. On Chart 2, the light green line represents the efficient frontier of a portfolio composed of two basic asset classes: equities and core fixed income1. The lowermost/leftmost point on this line represents 100% core fixed income and 0% equity. As you move to the right, the percentage of equity increases until the uppermost/rightmost point on the line, which represents 0% core fixed income and 100% equity.
The dark green line shows the same portfolio but adds a 20% allocation to high yield bonds2. The leftmost/lowermost point on the dark green line represents 20% high yield and 80% core fixed income. As you move to the right, the percentage of equity increases and the percentage of core fixed income decreases, but the percentage of high yield remains 20% throughout. The rightmost/uppermost point on the dark green line represents 20% high yield and 80% equity.
As shown in the chart, adding a 20% allocation to high yield would have enabled an investor in a basic core fixed income/equity portfolio to either increase their return for the same level of risk, or decrease their risk for the same level of return over this 25 year period.
#3 Spreads Relative to the Default Rate
As the number of defaults in the market increases, intuition tells us that investors should demand a higher yield to compensate them for increased risk. Empirical evidence supports this claim, as the correlation between high yield spreads and the high yield default rate is positive 0.56 over the past 25 years. The reason that the correlation is not closer to 1.0 is because the default rate is a backward-looking metric focused on actual defaults and the spread over Treasuries is a forward-looking metric reflecting the market’s sentiment about the future. When spreads exceed the default rate by a wide margin, as shown in Chart 3, the implication is that the market believes the default rate is likely to increase going forward. If the default rate does not increase, or increases marginally, then the implication is that spreads are likely to contract—a positive development for high yield investors.
Because default rates are near all-time lows, we believe the default rate is likely to rise/revert to more “normal” levels. Current spreads, however, imply a default rate close to 10%--a level that we view as exceedingly pessimistic.
#4 Incremental Yield Pickup
High yield spreads over Treasuries are wide for two reasons: 1) the yield-to-worst (YTW) for the high yield market is high and 2) Treasury rates are low. From an investor's perspective, paltry Treasury rates might make alternative investments more appealing relative to Treasuries, but it says nothing about the attractiveness of investment alternatives in absolute terms. In other words, wide high yield spreads could simply indicate that high yield is the better of two bad options. Therefore, rather than show the yield difference between high yield bonds and Treasury bonds (i.e. "spreads"), Chart 4 shows the relationship between high yield bonds and investment grade corporate bonds3. As highlighted in Chart 4, the YTW for high yield corporate bonds is normally 1.7x higher than the YTW for investment grade corporate bonds. As shown in Chart 4, however, it is 2.2x higher—nearly 30% higher than average.
#5 Wide Spread Distribution
Chart 5 highlights the distribution of spreads in the market. In May of 2007 (pre-financial crisis), spreads were not only narrow but were highly concentrated between 1-3%. In April of 2009 (the heart of the financial crisis), spreads were not only wide but were widely dispersed. We prefer markets composed of bonds offering a wide range of yields as opposed to a tight/clustered market. The former bestows vast opportunities for managers with distinct research advantages.
As illustrated in Chart 5, the market is more contracted than the extraordinary April 2009 market, but we believe it remains attractive for bottom-up credit researchers—opportunities abound.
#6 Annual Returns
Chart 6 depicts the calendar year returns for the BofA Merrill Lynch High Yield Master II Index since its inception—1987 was its first full calendar year. Only 5 of these 25 calendar year periods were negative. Until the -26% return in 2008, the worst calendar return had been -5% in 2000. Of course, past performance is no guarantee of future results. We have shown this to numerous investors, however, and most have been surprised that there have been so few negative years.
#7 Long-Term Returns
Chart 7 takes a longer-term view by highlighting the 10-year rolling returns for high yield, US equities, and international equities4. We do not claim that high yield is a stable asset class, but it has certainly been less volatile than equities. As depicted in Chart 7, high yield has never had a negative return over a ten year period—a claim that equities cannot make.
#8 Decrease in Leverage
Since the financial crisis, the market has undergone one of the largest and fastest financial deleveraging efforts in history. Managements have implemented aggressive cost-cutting programs, which has improved margins and created tremendous operating leverage. When these companies' revenues recovered, earnings and cash flows reached record levels. Many companies have used this cash to improve their balance sheets by paying down debt. Chart 8 shows the leverage for companies in the high yield market as defined by total debt to earnings before interest taxes depreciation and amortization ("EBITDA"). Leverage has declined considerably from the 2009 peak— companies appear to be in much better financial condition.
#9 Upgrade/Downgrade Ratio
Plummeting default rates and improved balance sheets has provided the rating agencies with reason for optimism. Consequently, upgrades have far exceeded downgrades recently, moving the upgrade/downgrade ratio near an all-time high. While this reflects the opinion of rating agencies, which have a less-than-stellar track record and whom we give little credence, it does further improve corporate health by reducing borrowing costs.
#10 Rising Interest Rate Environments
Chart 10 highlights five previous periods of rising interest rates since the inception of the BofA Merrill Lynch Master II High Yield Index. An increase in Treasury rates means a decrease in Treasury bond prices, but it does not necessarily mean a decrease in high yield bond prices. In fact, during each of these five previous rising rate periods the high yield market posted positive returns, ranging from +2% to +69%. To the surprise of many, the high yield market has actually performed better during periods of rising rates than it has during periods of falling rates. The table below shows the average annualized return of high yield bonds, investment grade bonds, and Treasuries in both rising (boxed in the Chart 10) and falling interest environments (non-boxed areas in Chart 10).
Contrary to investment grade bonds, high yield performance is primarily influenced by changes in the credit environment and economic growth rather than changes in interest rates. Most of the time, rising rates have coincided with economic growth—an environment normally conducive to high yield.
This is important because many prominent economists and investors believe an interest rate rise is inescapable. As depicted in the previous chart, interest rates have been in a secular decline for the past two and a half decades—a trend that many believe is likely to reverse.
Summary
Macroeconomic concerns in the marketplace are unnerving to say the least, but we believe these concerns have produced a compelling valuation opportunity for high yield investors. Spreads have blown out despite considerable improvement in fundamentals—most notable has been the strengthening of balance sheets. We believe defaults may pick up from record lows but should remain well below levels implied by current spreads. The ramifications of a disorderly European sovereign debt default and tighter liquidity in the high yield market remain threats, but we believe the attractive yields and strong fundamentals more-than-compensate for the risks at hand—and present a compelling case for investing in high yield in 2012.
Ray Kennedy and Mark Hudoff
Portfolio Managers
All investments contain risk and may lose value. Investing in the debt securities is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investment in lower-rated and non-rated securities presents a greater risk of loss to principal and interest than higher-rated securities.
Credit cycles vary in both length and volatility. Past credit cycles will differ from current or future cycles.
All references to high yield based on BofA Merrill Lynch US High Yield Master II Index. Investment grade bonds—Mortgage: BofAML US Mortgage Master Index. Corporate: BofAML US Corporate Master Index. Treasury: Barclays Capital US 10-Year Treasury Bellwether.
Data source(s): Chart 1: Morgan Stanley, Bloomberg, H&W. Charts 2-3, 5-7; Bloomberg, H&W. Chart 4: CreditSights, Bloomberg, H&W. Chart 8: JPMorgan, Capital IQ, H&W. Chart 9: JPMorgan, H&W. Chart 10: Barclays, Bloomberg, H&W.
1 S&P 500® Index and BofAML US Corporate, Government & Mortgage Index. 2 BofAML US High Yield Master II Index.
3 BofAML Master II Index and BofAML US Corporate Master Index. 4 BofAML Master II Index, S&P Index and MSCI EAFE Index. 5 High Yield: BofAML Master II Index. Investment Grade: BofAML Corp., Gov’t & Mtg Index. Treasuries: Barclays 10-Year Treasury.
©2012 Hotchkis & Wiley. All rights reserved. Any unauthorized use or disclosure is prohibited. This presentation is circulated for general information only, and does not have regard to the specific investment objectives, financial situation and particular needs of any specific person who may see this report. The research herein is for illustration purposes only. It is not intended to be, and should not be, relied on for investment advice.
Information obtained from independent sources is considered reliable, but H&W cannot guarantee its accuracy or completeness. The opinions expressed are subject to change and any forecasts made cannot be guaranteed. H&W has no obligation to provide revised opinions in the event of changed circumstances.
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