With yields up to 700 basis points above investment grade, junk bonds are attracting more money than ever. Are investors underestimating the risk of default?
By Laurie Kaplan Singh
April 2002
Institutional Investor Magazine
For several years inves-tors resisted the tempting yields of junk bonds, as they fretted about a weakening economy and looming defaults. Recently, though, they’ve felt more sanguine about a coming recovery and have stocked up on the asset class. Case in point: In January California Public Employees’ Retirement System, the largest U.S. pension fund, doubled its allocation to junk, to 10 percent of domestic fixed-income assets, more than twice the market weighting.
With junk bonds now yielding between 8 percent and 12 percent, or roughly 300 to 700 basis points over investment-grade bonds, the allure of high yield is clear. And CalPERS isn’t the only investor to notice. High-yield mutual funds are attracting assets at an impressive clip. The group took in $10.2 billion in new assets in 2001 (compared with asset outflows of $10.1 billion in 2000). An additional $4.6 billion flowed in between January 1 and March 13, according to Arcata, California-based AMG Data Services.
Are these investors so attracted to sky-high yields that they’re missing the huge underlying credit risks? Didn’t they hear the news about Enron Corp.? Or have they got the timing - when prices are at their cheapest and the credit concerns are near their highest - just about right?
The most recent buyers are definitely not too late. The performance of high-yield bonds has repeatedly disappointed in recent years. They have underperformed both investment-grade corporates and Treasuries since 1997, when they rose 13.27 percent. Despite receiving widespread media attention early last year as a surefire bond bet, high yields returned a measly 4.48 percent in 2001, less than Treasuries’ 6.74 percent and far worse than investment grades’ 10.7 percent. Relatively speaking, though, 2001 was much better than 2000, when Merrill Lynch & Co.'s U.S. high-yield master II index returned -5.11 percent, versus 13.14 percent for Treasuries and 9.14 percent for investment-grade bonds.
More important than recent returns, however, is the credit risk inherent in junk bonds. Enron is only the most extreme example of U.S. companies’ credit woes. “Corporate balance sheets are highly leveraged, and there’s still a lot of event risk in the system,” concedes James Kelsoe Jr., manager of Morgan Keegan High Income Fund, the top-performing high-yield-bond fund over the past two years.
“It has been a horrible environment for corporate bonds,” says Kelsoe, whose own fund thrived, gaining 17.44 percent in 2000 and 17.9 percent in 2001 because of a shrewd focus on quality. “The corporate landscape has been littered with mines that have been devastating to performance.”
According to Edward Altman, a professor of finance at New York University’s Leonard N. Stern School of Business, corporate bond default rates rose steadily between 1997 and 2001, from 1.25 percent to 9.8 percent - just below the record high of 10.3 percent set in 1991. Fitch Ratings computes an even higher default rate for last year of 12.9 percent - an all-time high, by the rating agency’s calculations.
High yield also didn’t get the same pop from declining interest rates that Treasuries and high-grade bonds enjoyed in the past year. Because of their credit sensitivity, junk bonds generally don’t respond as quickly to shifts in rates. As the Treasury yield curve dropped, investment-grade bonds benefited much more than high yield, notes Nathan Kehm, comanager of $564 million Federated High Yield Trust (down 1.8 percent last year).
Last year high yields’ vulnerability to outside events was again driven home. The bonds delivered strong returns through the end of August, gaining 5.89 percent. But they gave back all of the gains - and then some - after September 11, when investors fled to quality. The market then rebounded in the fourth quarter, when bonds rated below triple-B outperformed their investment-grade counterparts by about 525 basis points. Amid indications of an economic recovery, the Merrill Lynch high-yield index returned 5.99 percent in the fourth quarter; in contrast, the Merrill Lynch corporate master index, a proxy for investment-grade bonds, returned 0.76 percent.
Although most segments of the high-yield-bond market have remained stable in this year’s first two months, two of its largest sectors - telecommunications and independent power generators - have been anything but quiescent. The Merrill Lynch U.S. high-yield telecom index dropped 13.52 percent through February 21, compared with a decline of 0.5 percent on the Merrill Lynch high-yield proxy. Thanks to Enron and continued defaults among telecom issuers like McLeodUSA and Global Crossing, “investors have been focusing on the disaster du jour,” says B. Daniel Evans, manager of the $526 million Merrill Lynch U.S. High Yield Fund, which gained 1.1 percent last year.
Despite all of its recent travails, junk’s prospects are bright, say some analysts. That’s largely because they expect the economy to rebound in the year’s second half. “Assuming the economy turns around as most people expect, high-yield bond returns should be excellent this year,” says NYU’s Altman. And for the moment at least, demand for high-yield products is strong.
On average, junk bonds are trading significantly above their typical long-term 450-basis-point premium to Treasuries. And as Mariarosa Verde, a senior director at Fitch Ratings in New York, points out, “The credit quality mix of the high-yield bond market is improving.” She notes that about 45 percent of the new issuance in 2001 consisted of double-B-rated bonds.
In the face of a difficult credit environment, especially for the more marginal issuers, default rates will remain well above the long-term norm of 4.6 percent for at least another year, Verde says. “Additional telecom companies will either file for bankruptcy or undergo debt restructurings,” she says.
Managing default risk, of course, has always been the key to a successful high-yield-bond strategy. “In high yield the first line of defense is good credit selection,” says Federated’s Kehm. “You need a rigorous process for examining the underlying cash flows. Over the long term it’s the person who’s the best at that who wins the race.”
To be sure, virtually all of the better-performing high-yield bond funds stress higher-quality issues. The top-performing $145 million Morgan Keegan High Income Fund achieves much of its yield from structured products - bonds backed by real estate, equipment leases and business and consumer debt - rated single-B or higher (about 60 percent of the fund’s assets). Straight corporate bonds rated single-B or higher claim an additional 25 percent of assets, and convertible bonds rated single-B or higher make up the remaining 15 percent. “Our best-performing assets over the past year have been deep-discount structured products that benefited from high prepayment rates and their lack of exposure to corporate event risk,” says Morgan Keegan’s Kelsoe.
The $289 million Columbia High Yield Fund (up 7.3 percent last year) also emphasizes the upper tiers of the credit spectrum. “Our ideal company has the potential to be upgraded to investment grade within a few years,” says co-manager Jeffrey Rippey.
Although Columbia High Yield Fund did buy telecom bonds during the 1997-2000 period - including Crown Castle International Corp., XO Communications, Level 3 Communications and McLeodUSA - its exposure to telecom in early 2000 was roughly 12 percent of assets, versus the sector’s 20.3 percent weighting in the Merrill Lynch high-yield index. The fund gained 5.4 percent in 2000, when the average high-yield bond fund lost 8.9 percent, according to Morningstar.
Rippey and co-manager Kurt Havnaer sold off almost all of their telecom bonds during 2001, when investor antipathy to the industry infected the higher-quality issues as well. After selling the fund’s Nextel Communications holdings in February, they now own only one telecom issue: Crown Castle International 10.75 percent senior notes, due August 1, 2011.
Currently, Rippey and Havnaer are keeping the bulk of their assets in cable television, health care, food, beverage and supermarket companies. Recent purchases include Cott Corp., the world’s largest supplier of retail-brand soft drinks, and Great Atlantic & Pacific Tea Co., which operates supermarkets and drugstores. Although Rippey and Havnaer believe the economy will start to grow again later this year, they’re not ready to buy bonds of cyclical companies. “We are being very cautious,” says Rippey.
On the other hand, Merrill’s Evans and Federated’s Kehm feel confident that the economic rebound will begin in the second quarter and boost cyclical industries like paper and specialty chemicals. “Many triple-B-rated industrial bonds are offering yields comparable to double-B-rated bonds, and they have much stronger balance sheets,” Kehm says. And with the cost of capital, energy prices and inventory levels all historically low, these companies are poised to do well as demand picks up.
Kehm is particularly optimistic about the prospects for wireless companies. Displaying even more of a contrarian streak, Evans has been adding to his fund’s stake in airline equipment trust certificates since September 11. The fund’s exposure to these securities, which are backed by the aircraft, is now about 3 percent of assets, nearly double the weighting of airline securities in the overall high-yield market. “We think the market is unduly penalizing the sector, so it’s attractive to us,” he says. Evans recently added to the fund’s position in US
Airways 10.375 percent equipment trust certificates, due March 1, 2013, at a price of 62. Before September 11 they were trading in the 80s. Eventually, he feels, improved security measures will restore the public’s confidence in flying and boost the values of airline bonds. When this happens, his fund will be ready.
