PRUDENTIAL FIXED INCOME Build America Bonds: High Quality in Long Maturities Short Maturity High Yield Bonds: Market Segmentation Creates a Timely Opportunity Michael J. Collins, CFA Senior Investment Officer and Credit Strategist Prudential Fixed Income
It would be an understatement to say that high yield bonds have performed tremendously well in the 15 months or so since the credit crisis began to ease in late 2008. The Barclay’s High Yield Index posted a blistering return of +58.2% in 2009, more than double the S&P 500’s return of +26.5%, and it tacked on an additional 4.5% in the first quarter of 2010. The yield “spread”, or differential, that high yield bonds offer over US Treasuries compressed dramatically over that time, declining by 1200 bps to their current level of approximately 600 bps. Some market observers believe that it is now too late to make an allocation to high yield bonds. While we certainly acknowledge diminished opportunities in certain parts of the high yield market, particularly in the most highly levered credits, higher quality high yield bonds in general still look attractive. In particular, market segmentation has created attractive relative value today in short maturity high yield bonds.
Market Segmentation Has Created an Attractive Opportunity in Short Maturity High Yield Bonds Market segmentation is an investment theory that attributes pricing anomalies in certain markets to different preferences or tendencies by investors in those markets. For example, investors in investment grade corporate bonds are often explicitly restricted from buying non-investment grade, or high yield, bonds. Conversely, many high yield investors deliberately avoid the highest quality/lowest yielding bonds within the high yield market because of their yield disadvantage relative to lower quality high yield bonds. These two dynamics, in fact, are largely responsible for the long-established structural attractiveness of higher quality high yield bonds relative to both investment grade bonds as well as to lower-rated high yield bonds. (See our paper, “The Sweet Spot Is Still Sweet Today”, dated January 2010, for a full discussion of this dynamic.)
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This relationship is even more exaggerated – in other words, higher quality high yield bonds are even more attractive – in short maturities, particularly during periods when short-term interest rates are exceptionally low and the US Treasury yield curve is therefore very steep. These factors are in place today. We define short maturity bonds as bonds slated to mature within the next two to three years or that are highly likely to be refinanced within that time. Given that the credit fundamentals of higher quality high yield bonds are stronger to start with, they are less dependent than other high yield bonds on a robust or sustained economic recovery. Furthermore, the improved (re)financing environment today significantly increases the likelihood that these shorter maturity higher quality securities will mature at par or be called/tendered for at prices above par.
A Driver of this Opportunity: Historically Low Short-Term US Treasury Yields As Figure 1 below illustrates, the Federal Reserve’s near-zero interest rate policy of the last 15 months has resulted in short-term US Treasury yields in the front of the yield curve that are close to zero. Even yields on three-year maturity US Treasuries are well below 2%. Figure 1 Short-Term US Treasury Yields Are Well Below 2% As of March 31, 2010 Yield to Maturity
4% 3% 2% 1%
1-Yr +0.5 %
2-Yr +1.0 %
3-Yr +1.6 %
3 4 Maturity (Years)
Source: Barclays Capital.
Investment grade corporate bond investors and high yield bond investors will each have different responses to the graph above. Investment grade corporate bond investors will pay close attention to it, as they focus heavily on the “spread”, or excess return, of an investment grade bond to US Treasuries. Unless a corporate bond is offering a wide enough spread over US Treasuries, many investment grade corporate bond investors won’t be interested in it. In today’s market, many investors consider a high quality investment grade corporate bond that provides +100 bps in excess return over US Treasuries to be attractive. Because US Treasury yields are so low, investment grade corporate bonds with two years to maturity can find willing buyers even at yields of only 2% or so. High yield bond investors, on the other hand, pay less attention to a high yield bond’s spread over US Treasuries. They are more focused on the absolute yield of the high yield bond. For this reason, most high yield bonds are quoted on a dollar price or an absolute yield basis instead of on a spread basis, as investment grade corporate bonds are. And speaking of absolute yields, most high yield investors are simply unwilling to buy a high yield bond with a yield to maturity of less than, say, 5%, especially one with little room for price appreciation because of its short maturity. However, other types of investors focused on relative value with low volatility may consider the yields of shorter maturity high yield bonds quite satisfactory. In fact, Figure 2 below shows that BB and B-rated short maturity high yield bonds, on average, yield more than 5% now, with spreads of approximately +400 bps to Treasuries. In today’s generally lower yield environment, with near-zero yields on cash, a 5% yield on a shorter maturity instrument looks pretty good to many investors.
Figure 2 Short Maturity High Yield Bonds Overall Now Yield More than 5% As of March 31, 2010 Yield to Maturity
2-Yr +5.7 %
2% 0% 1
3 4 Maturity (Years)
Source: Barclays Capital.
Because many traditional high yield investors do not evaluate the market on an “excess return to US Treasuries” basis, when one does evaluate the high yield market that way, some interesting themes can emerge. As Figure 3 below shows, the US high yield market “spread curve” is currently flat to slightly inverted, with shorter maturity high yield bonds offering a higher relative spread over US Treasuries than longer maturity high yield bonds. This anomaly is driven largely by high yield investors’ focus on yield along with the exceptionally steep US Treasury curve today. It means that investors in these short maturity higher quality high yield bonds today gain a relatively larger spread over US Treasuries than they would for a riskier, longer-maturity bond.
Spread to Treasuries
Figure 3 Short Maturity High Yield Bonds Now Offer +338 Bps Over Investment Grade Bonds As of March 31, 2010 500 450 400 350 300 250 200 150 100
+466 bps +415 bps 1-Yr
+258 bps +157 bps
Maturity (Years) Source: Barclays Capital.
Short Maturity High Yield Bonds Although short maturity high yield issues are attractive from a number of standpoints, on a practical basis there are only a few dozen such issues that we believe provide an appropriate level of spread, credit quality, and liquidity for client portfolios. We have excluded the highest-yielding, riskiest bonds from the universe. Other bonds, although they may be appropriate from a credit quality standpoint, cannot be purchased in reasonable size. In Table 1 below, we list a few examples of bonds with an attractive combination of short maturity, attractive yields, and low default and refinancing risk.
Table 1 Examples of Short Maturity High Yield Bonds All data as of March 31, 2010 Issuer Sprint Mirant Americas Ford Motor Credit GMAC Charter Comm GameStop Average
7.625% 8.3% 9.875% 6.875% 8% 8%
1/30/11 5/1/11 8/10/11 9/15/11 4/30/12 10/1/12*
102.75 103.00 106.00 102.00 106.00 103.75
Yield (%) 4.09% 5.36% 5.18% 5.41% 4.09% 4.22% 4.73%
Spread vs Treasury (bps) +380 bps +490 bps +454 bps +471 bps +383 bps +398 bps +429 bps
*Upcoming call date. Source of data: Bloomberg. As of March 31, 2010. Source of ratings: Moody’s. Securities are shown for illustrative purposes only. These are not intended as recommendations or indicative of Prudential Fixed Income’s actual holdings.
What Are the Risks of These Securities? There are three primary risks to short maturity high yield securities: credit risk, refinancing risk, and market risk. By far, the most significant risk is credit risk. A default by even just one issuer can wipe out the excess spread generated by a portfolio’s entire holdings of short maturity high yield bonds. Naturally, then, it is imperative to carefully scrutinize each individual issuer prior to purchase and while held in a portfolio to minimize default risk. Although default risk may be mitigated because of the short maturities of the issuers, it is still a risk that must be closely analyzed and monitored. We would also note that, at the time of this writing in April 2010, credit quality in general is on the upswing and defaults are expected to decline over the near-term. The second risk to short maturity high yield securities is liquidity risk. Quite simply, the success of a strategy employing short maturity high yield bonds hinges on the ability of the issuers to pay off their short maturity debt when it comes due. During times of extreme market stress, such as that seen in 2008, even creditworthy companies can have temporary trouble accessing the markets to refinance their outstanding debt, potentially leading to an inability to pay off existing bondholders. To properly assess this risk, investors must carefully review the issuer’s cash balances, its access to cash via a credit facility, its ability to generate free cash flow by operations or asset sales, and its access to the capital markets. Periods of extreme market stress can also lead to disruptive price volatility, even in short maturities. In late 2008, systematic redemptions from high yield bond mutual funds and the widespread portfolio deleveraging that impacted many fixed income securities led to massive forced selling of many bonds. When a portfolio manager of a mutual fund receives a redemption request, he or she is naturally required to sell bonds to raise cash to meet the redemption, unless the fund is carrying a sufficiently-sized cash position. In an “unplanned liquidation” situation like this, many high yield portfolio managers will sell the lowest-yielding, most “cash-like” bonds they own, so as not to overly reduce the portfolio’s overall yield. Often, this results in heavier-than-normal selling of shortmaturity, higher quality high yield bonds, with the sellers having little bargaining power to hold out for higher prices. Today, however, the fixed income markets have largely resumed normal functioning, and liquidity has been restored. Even companies that are riskier from an overall credit quality standpoint can generally access the high yield market in today’s environment. Furthermore, after several quarters of hunkering down and cutting expenses during the depths of the credit crisis, many corporations have now replenished their cash balances. These companies are in a much better position to pay off their outstanding short-term debt as it comes due. This constructive backdrop gives us the confidence to invest in short maturity high yield bonds today.
Using These Instruments to Enhance a Fixed Income Portfolio There are a number of roles short maturity higher quality high yield securities can play in broader fixed income portfolios today. High Yield Portfolios: The higher quality and short maturities of these bonds make them among the least risky high yield securities. In this regard, they can help offset some of the risk of lower-quality high yield bonds in a high yield portfolio. The lower volatility and lower interest rate sensitivity of short maturity high yield bonds can also improve the overall risk profile of such portfolios. Core Plus Portfolios: The favorable risk/return characteristics of these types of bonds also may make them ideal candidates for Core Plus portfolios. Holding short maturity high yield bonds vs. the many short duration government bonds and agency mortgages in the Barclay’s Aggregate Index appears to be a great relative value trade at the current time. Credit Opportunity Portfolios: Credit Opportunity portfolios typically seek good risk-adjusted returns relative to LIBOR. The favorable absolute risk/return characteristics of short maturity high yield bonds, and their significant current spreads versus LIBOR, make them attractive today for these types of opportunistic portfolios. Short Duration Credit Portfolios: With money market rates so low and investors also concerned about interest rate risk, short duration portfolios that offer even modest levels of yields have garnered much attention. A diversified short duration credit portfolio may be comprised of short duration corporate bonds, select structured product securities, senior bank loans, and short maturity high yield bonds.
Conclusion Segmentation within the credit markets has created attractive relative value today in short maturity high yield bonds. The combination of their short maturities, yield, and low default risk make these bonds appealing, particularly in light of the near-zero yields on cash instruments. For these reasons, there are a number of roles short maturity higher quality high yield securities can play in broader fixed income portfolios today.
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