High-yield bonds have given stocks a run for investors' money this year, and a tepid U.S. economic recovery could keep institutional money flowing to that corner of the credit market, according to some market watchers.
High-yield bonds have given stocks a run for investors' money this year, and a tepid U.S. economic recovery could keep institutional money flowing to that corner of the credit market, according to some market watchers.
Even with the Merrill Lynch U.S. High Yield Master II Index surging 48.5% this year through Sept. 30, investors have continued to allocate money to high-yield bonds.
For example, on Aug. 7, the board of the $12.6 billion Kentucky Teachers' Retirement System hired Fort Washington Investment Advisors Inc. to manage a $200 million high-yield-bond mandate, its first allocation to that market segment, according to a spokesman for the system.
According to institutional sales executives who declined to be identified, other pension funds looking now to award U.S. high-yield-bond mandates of $100 million or more include the $3 billion Kern County Employees' Retirement Association, the $23 billion Northrop Grumman Corp. pension plan and Germany's BMW pension plan.
Investors under pressure to add risk in the face of continued economic uncertainty can still turn to high-yield bonds for “competitive returns with better downside protection” than equities, said Thomas P. O'Reilly, a managing director with Neuberger Berman LLC and a portfolio manager of the firm's $6.5 billion high-yield-bond strategy.
The definition of “competitive” might be in flux following the S&P 500's 59% surge from early March, which turned the sharp sell-off in January and February into a gain of about 20% for the first three quarters of the year.
The flow of money into high-yield bonds began picking up late last year after market turmoil swelled their spreads over Treasuries from a historic average of about 400 basis points to more than 1,800 basis points, promising windfall capital gains for investors bold enough to put money in at that moment.
According to public fund institutional investor data tracked by Eager Davis & Holmes LLC, 15 high-yield-bond mandates were awarded in the fourth quarter of 2008, just one shy of the combined total for the three previous quarters.
The first and second quarters this year, meanwhile, saw 12 and nine mandates awarded, respectively, with combined assets placed for the three-quarter period ended June 30 coming to just under $2.4 billion.
It was a “once-in-a-lifetime opportunity to buy credit” for firms that believe in swimming against the tide, such as Pacific Investment Management Co. LLC, said Mark R. Kiesel, a managing director and global head of the corporate-bond portfolio management group at Pimco. Late last year, Pimco officials were “pounding the table,” calling on clients to look at high yield, he said.
Data from eVestmentAlliance LLC suggest that some clients were listening: Pimco's high-yield strategy pulled in more than $1 billion of net inflows in the first half.
Ted L. Disabato, the managing member of investment consultant Disabato Advisers LLC, said that high-yield bonds figured prominently in a two-step deviation from the “rule book” his firm uses to keep clients from getting “run over by a truck” — one of only two such moments in his 25-year career.
By mid-2008, he said, a number of his clients had halved equity weightings that had come to about 60% of their portfolios, putting the balance in Treasury bonds. Then in February, with top economic policymakers clearly signaling their intention to do “whatever it takes” to support the financial system, the Treasury bond allocations were shifted to high-yield bonds.
Mr. Disabato said that his clients' returns have been “top quartile in 2008 and top quartile in 2009.” He declined to identify them.
A Sept. 28 report on global institutional client flows by money manager consultant Casey Quirk & Associates provided further signs of investor interest, citing high yield as one of only three fixed-income segments, out of a total of 12, with net inflows for the 12-month period ended June 30. Those inflows amounted to 6% of total client assets in high yield at the start of that 12-month period.
With spreads between high-yield and Treasury bonds already below 800 basis points, however, the lure for opportunistic investors hunting for outsized gains is greatly diminished.
Still, with the equity and bond markets sending mixed signals on what sort of economic recovery is coming down the pike, junk bonds should continue to attract interest.
In a V-shaped recovery, equities “would outperform high yield due to price-to-earnings multiple expansion,” but in the likelier event of slow growth, “high yield would outperform equities,” said Ann H. Benjamin, a managing director with Neuberger Berman. She is also chief investment officer and lead portfolio manager for the firm's high-yield-bond portfolios and blended-credit strategies.
OTHER EXPECTATIONS
Though demand for high yield persists, investors coming to the table now have far different expectations from those who invested at the height of the turmoil, said Mark Ahern, a managing director at Seix Investment Advisors LLC.
Investors are looking at clipping coupons of 7%-9% on better-grade high-yield bonds, a relatively safe way to garner the gains needed to keep pace with their liabilities, he said.
Ms. Benjamin said that Neuberger Berman continues to see “good demand from institutional investors” seeking equitylike returns with relatively low volatility.
With some market watchers expecting default rates on high-yield bonds to peak this year at 9% or so, and fall to less than half that rate next year, “we expect good returns to continue,” she said.
Mr. Kiesel said his firm is far less optimistic about the economic outlook, seeing little reason to expect the all-important U.S. consumer to catch a second wind anytime soon. Pimco sees default rates staying in the 7% to 8% range next year.
High-yield bonds remain less risky than stocks, but with less compelling valuations to compensate for downside risks, investors now would probably be wise to move higher up the corporate capital structure and into higher-quality companies in the investment-grade-corporate-bond market, which have less balance sheet leverage, Mr. Kiesel said.
“If you are bullish on stocks and the economy, and proven right, then high yield will likely outperform investment-grade corporate bonds,” he said. But “if you are bearish on stocks and the economy, and proven right, then high yield will likely underperform investment-grade corporate bonds.
Douglas Appell is a reporter for sister publication Pensions & Investments.
