Red Sky in the Morn', Junk Bond Investors Be Warn'd.

Investor appetite for income has pushed yields and spreads on high-yield bonds to very low levels, while corporate borrowers have fed that demand with record issuance of new debt. On top of low yields and heavy issuance, bond dealers have retreated from corporate bonds in response to new financial regulations. As a result of these factors, we believe now is a particularly risky time to invest in high-yield bonds. Here we offer some of our suggestions for seeking income and yield with less risk.

If you have invested in high-yield bonds over the last five years since the global financial crisis, you have likely enjoyed an excellent run. The annualized return on the Bank of America Merrill Lynch (BAML) High Yield Index, a commonly used benchmark of high-yield bonds, was 18.18% over the five years through March 31, 2014, a period that began just as markets bottomed in the first quarter of 2009. By comparison, the average annual return on the BAML 5-7 Year US Treasury Index was just 3.26% over the same period.

The gradual economic recovery over the last five years, combined with unprecedented monetary accommodation, have kept real and nominal interest rates very low and fueled investor appetite for higher yield. Yield spreads are now so tight that high-yield investors can only cross their fingers and hope this trend continues. If it does, so will the incentives for borrowers to tempt the market with lower quality offerings. If the economy weakens, high-yield defaults would likely rise, as would spreads with growing risk aversion.

The high risk of low spreads

The spread available from high-yield bonds has historically been a decent predictor of future returns: when the spread was low, so was the compensation for bearing credit risk relative to "safe" government bonds. The yield spread¹ of the BAML High Yield Index over government bonds was 3.71% at the end of April, the lowest level since July 2007.

To model the relationship between spread and return premium, we analyzed the relationship between the high-yield spread and the five-year annualized excess return of the BAML High Yield Index over the BAML Treasury Index for each quarter end from 12/31/1996 to 3/31/2009. We chose a five-year return horizon because it approximately matches the typical duration of the high-yield and 5-7 year Treasury indices. The relationship is nicely linear, with an R-squared of 71%, which means 71% of the variation in five-year excess returns for the High Yield Index could be explained by the spread at the beginning of the five-year period.

The bad news is that this model predicts excess return for the BAML High Yield Index of minus 1.83% based on the current spread of 3.71%. The model suggests that for the 13 years from December 1996 to March 2009 — a period that contained two major default cycles — a beginning spread of 5.10% was necessary to compensate investors for future credit losses and other risks just to break even with the return of government bonds of similar maturity.Index to see whether the host country outperformed.

The good news is that longer-term data suggest the 5.10% estimate could be cut roughly in half. Data from S&P on five-year cumulative default rates in the US from 1981 to 2011, weighted to match the current credit rating profile of the BAML High Yield Index, indicate an annual default rate of 4.11%. Meanwhile, S&P's corporate default recovery data from 1987 to 2013, again weighted to match the current rating profile, suggest a loss of 66¢ on each dollar of debt in default. Combining these historical default and recovery estimates leads to an annual default-loss estimate of 2.67%. If the BAML High Yield Index experienced an equivalent level of default losses for the next five years, it would provide a return of approximately 1.04% in excess of government bonds, all else equal. Note that this estimate excludes other risks such as a rise in spreads or decline in liquidity.

Finally, there is no guarantee that future excess returns or default rates will resemble the past; to that end we might look at Moody's forecast for 2014 US defaults, which is 2.4%. Such a historically low default rate, were it to continue, translates to about 1.5% of credit losses after factoring in recovery value of defaulted bonds. Caveat: In 2007, Moody's was buried under a pile of AAA ratings it assigned to subprime mortgage debt; we would hope they have learned something about extrapolating recent trends into the future, but this forecast makes us gulp.

Thus we have a range of annual high-yield loss estimates, from 1.6% to 5.1%:

  • 1.6% based on Moody's 2014 forecast
  • 2.4% based on more than three decades of default and recovery estimates
  • 5.1% based on 13 years of spread and excess return over the last two credit cycles

A liquidity crisis brewing?

Credit risk is not the only type of risk posed by speculative bonds; liquidity risk is another worth special mention. Default-loss estimates calculated above do not include losses (both realized and in the form of opportunity costs) that might be incurred as a result of the inability to sell a bond at a "fair" price. Incidentally, this is a risk not faced by an index, although index values can be influenced by liquidity-stressed prices.

In the evolution of the corporate debt market in recent years, we see three conditions that are increasingly ominous:

1. Mutual funds and ETFs have substantially expanded their footprint in corporate debt.

The percentage of corporate and foreign bonds held by mutual funds and exchange-traded funds (ETFs) has more than doubled in the last decade, rising from 7.4% in 2003 to 16.2% at the end of 2013.² Holdings by insurance companies and pensions — traditionally among the biggest holders of corporate bonds — have dropped from 32.8% to 21.2% over the same period. Insurers and pensions typically hold their bonds to maturity, with payments of principal and interest structured to offset their anticipated liabilities. Mutual funds, on the other hand, offer daily liquidity, which means they must be able to quickly liquidate a portion of their portfolios to meet demand for redemptions. Mutual funds are forced sellers in such conditions, and it is worrisome that the ratio of strong hands (insurers and pensions) to weak hands (mutual funds and ETFs) has decreased so dramatically in the past decade from 4.4 to 1.3.

2. Dealers have retreated from making markets in corporate debt.

Also worrisome is that corporate bond dealers have reduced their inventories dramatically in relation to the size of the corporate bond market, particularly since 2007. Regulations enacted after the financial crisis cut into the profitability of the market-making role. At the end of 2013, dealer inventories represented just 6.1% of corporate and foreign bonds held by mutual funds and ETFs, down from 42.5% at the end of 2007, and less than half the 12.6% at the end of 2008 in what was then a full-scale liquidity panic.

Retiring baby boomers' need for income has recently pushed up demand for high-yield mutual funds and ETFs, a trend expected to continue for the next 15 years or so. But this source of demand is prone to waves of fear and greed. According to Morningstar, investor returns from taxable bond funds in the 10 years through December 31, 2013, trailed the performance of the funds themselves by 2.24% annually as a result of those investors' poor timing decisions.³ The combination of poor timing and very thin underlying liquidity could be the recipe for major bond market turmoil.

3. Large, return-chasing inflows have encouraged investment managers to load their funds with credit and liquidity risk.

Bonds rated CCC or below as having the highest chance of defaults have been the best performers in high yield over the past three and five years. The pattern continues with B outperforming BB (the high-yield universe is generally agreed to include bonds rated BB+ and lower).

The better returns for fund managers who have taken the most credit risk have attracted more inflows, but those managers have to find something to do with the new money investors send them. Most likely this means buying more of the riskiest bonds. The Wall Street Journal reports that "among the 10 largest US bond funds at the end of 2013, the four with the fastest growth in assets since 2008 held an average 20% of their investments in bonds rated below investment grade…At the remaining six funds, low-rated debt accounted for 1.4% of the portfolio."4

"If you can't join 'em, lick 'em" — Warren Buffet

As managers of the Sextant Global High Income Fund, our investment objectives and constraints more or less require us to hold some high-yield debt.5 So what opportunities are we finding to avoid the excesses we see in the high-yield market? Here are some ideas:

  1. Tread carefully in the lower credit tiers. Our analysis shows spreads over potential default losses decreasing with a decrease in credit quality.
  2. Look for collateral. A liquidity panic can morph into a solvency crisis if borrowers cannot rollover their maturing debts with new bonds, as we saw in 2008. We seek bonds of companies that control readily-marketable assets, such as pipelines or quality brands.
  3. Consider stocks. We find a decent selection high-quality companies with dividend yields currently above 4%, not far off from the yield available from a portfolio of high-yield bonds. While stocks are generally more volatile than high-yield bonds, they offer better liquidity. They also offer some inflation protection, as companies may be able to raise prices to drive higher revenues, profits, and ultimately higher dividends if inflation picks up. And, if a panic does erupt in high-yield bonds — particularly if the panic is contained there — quality dividend stocks should offer some welcome diversification.
  4. Be wary of large bond mutual funds and high-yield ETFs. Large bond funds with exposure to high yield may have a harder time moving their big blocks of bonds in the event of a redemption-fueled liquidity crisis. These funds are also less choosy during periods of inflows, as they may need to take pieces from many new issues in order to stay fully invested. High-yield ETFs offer institutional clients "in-kind" purchases and redemptions (swapping securities for securities) to help keep traded prices close to the NAV, but ultimately real-money buyers are necessary to exit trades. If liquidity is tight, distressed prices could be the tail that wags the NAV.
  5. Look to the periphery. With increasingly speculative issuers coming out of the woodwork to issue debt at historically low yields, we look for bonds that lack natural buyers. For example, municipal bond funds — previously the natural buyers of Puerto Rican government bonds — fled that market last year in anticipation of a downgrade to junk, sending yields from around 5% to 9%. And these are tax-free yields. Although the risks in Puerto Rico are very real, we do not view those risks as strongly correlated with risks in high-yield corporate debt, so there is diversification potential.

The search for yield is characteristic of the low-interest-rate environment of the last decade. Prior to 2008, that search fed demand for novel and complex forms of structured credit, the most infamous among them being opaque packages of subprime mortgage debt. In the five years between 2003 and 2007, net issuance of structured credit amounted to $2.94 trillion before the market imploded on itself. Do we dare mention that in the five years from 2009 to 2013, net issuance of nonfinancial corporate debt totaled $2.84 trillion, an eerily similar amount?6 In the 2000s, investment banks loaded credulous investors with highly-rated but ultimately toxic concoctions of low-quality debt sliced into non-transparent structures. Having been burned so badly, investors still hungry for yield have chosen to take credit risk in the clear packaging of vanilla corporate bonds. While we see that as an improvement, today's low spreads, declining quality, and dubious liquidity could still leave investors short of a happy ending this time.


¹1 Technically, this is the "option adjusted spread" which is a weighted average spread of each bond in the index over a duration- and convexity-matched government bond.

² Source: Federal Reserve Financial Accounts (Z.1)

³ Kinnel, Russel. "Mind the Gap 2014." Morningstar. February 27, 2014.

4 Wirz, Matt. "New Fund Stars Ride Junk Bonds to the Top." Wall Street Journal. May 27, 2014.

5 High-yield bonds comprised 29% of the Fund as of March 31, 2014.

6 Source: Federal Reserve Financial Accounts (Z.1)

Copyright 2014 Saturna Capital Corporation and/or its affiliates. All rights reserved. Vol. 8 · No. 6

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