Chad Smith of Blackstone says High Yield Bonds and Loans: Still Have Legs
By Chad Smith
Apr 03,2014 11:36 AM
Since the 2008 financial crisis, high yield bonds and loans have been among the best-performing asset classes across global markets.
They were also clear fixed income standouts in 2013.
High yield bonds and loans offer some insulation from interest rate risk and historically have outperformed in rising rate environments.
While expectations may need to be adjusted after the strong run, high yield bonds and loans still deserve a core place in investor portfolios.
Over the five years since the 2008 financial crisis, high yield bonds and loans have been among the best-performing asset classes in global financial markets. And they delivered that performance with much less volatility than the other top performers. While high yield bonds and loans trailed high-flying equities in 2013, they were the best-performing sectors in fixed income. This success has led many to question whether it’s time to sell and move on, or do high yield bonds and loans continue to play a valuable role in investor portfolios? BlackRock’s Jim Keenan and Leland Hart still see a lot to like:
Favorable risk/reward. An environment characterized by economic improvement, accommodative central banks, company strength and low default rates is traditionally very supportive of the high yield bond and loan markets.
Lower interest rate sensitivity. Typically, when interest rates rise, the prices of traditional bonds fall. High yield and loans can offer insulation from this risk. In the six years that rates have risen over the past two decades, either high yield or loans has been the top-performing fixed income sector.
Essential complement to stocks and traditional bonds. Over the past 20 years, high yield bonds have delivered 84% of the return of the S&P 500 with only 60% of the volatility, making them an attractive equity proxy. And versus other fixed income, high yield and loans offer important diversification benefits, having a low to zero correlation to investment-grade bonds and a zero to negative correlation to Treasuries.
*See below for represented indexes.
High yield was the best-performing fixed income sector in 2013. What made it so?
We had been pounding the table about the value in the high yield bond and loan markets over the last several years, 2013 included. Our thinking was this: You had a market that was improving and central banks globally that were highly accommodative and intent on avoiding deflation/recession. It was a market-stimulative environment. As the risk of deflation was successfully reduced and rates threatened to rise, we started to see investors leave those high-quality fixed income vehicles that are more sensitive to rate action (i.e., those that lose value when rates rise). This included municipal debt, U.S. Treasury debt and even investment-grade credit. Fixed income investors instead wanted shorter-duration assets, like high yield, bank loans and even multi-asset fixed income strategies, whose prices are not walloped by interest rate moves.
Because neither high yield bonds nor loans are as exposed to the steepening of the yield curve and duration risk, they were able to produce returns of 7.4% and 5.3%, respectively, last year. They simply represented better relative value versus other fixed income options.
*See below for represented indexes.
What should investors expect next?
For loans, it appears 2014 will be quite similar to 2013: a benign credit environment (translating into low defaults), still high spreads and a continued outlook for rising rates. That means investors might expect coupon-like performance similar to that achieved in 2013, and that should once again compare quite well to the other fixed income options out there.
Notably, the things that could impact performance in the loan market over the next year or two are most likely going to be exogenous to the loan market itself. It won’t be the borrowers themselves not repaying. Companies are in pretty good shape and default rates should remain low. In that environment, investors can expect to be paid their coupons (currently 4.8%, but drifting down gradually due to refinancing). Even in the case of an external shock, you’re still getting your coupon return because loans trade at par.
What about high yield bonds? Is the run over?
Relative to other fixed income assets, conditions for high yield bonds generally remain favorable as we start 2014. The yield curve is likely to continue steepening, for many of the same reasons it did last year: The economy is improving and companies are exhibiting strength. Central banks are removing stimulus, but you still have an accommodative Fed content to maintain its zero interest rate policy. Inflation also looks set to remain low given the slack in the labor market.
That said, we do think investors should begin adjusting their expectations this year. Last year we forecasted coupon-like returns, and that is just what we got. Today, we think high yield is closer to fair value, and while not highly sensitive to interest rates, prices will still be pressured a bit if rates continue to rise, as we expect. Some of that could be offset by tightening spreads, so our base case is a 5% to 6% return, with the possibility of slightly lower returns if rates rise more than expected—call it a 3% to 6% range to reflect uncertainty about the path of interest rates.
Is it time to start shifting out of high yield bonds and loans?
Both still make a lot of sense in investor portfolios. You have a low-duration, or in the case of loans, a no-duration asset class that offers insulation from volatile rates. The economy is improving, underlying company risk is still low and we expect defaults to remain low. (Trailing 12-month default rates are currently 0.6% for high yield bonds and 1.6% for loans.) We don’t think either asset class is a sell until the economy begins to slow and default risk rises, and that is most likely on the other side of a Fed tightening, still a ways away. That said, as the cycle matures, as companies grow less and less conservative and as interest rates start to settle at higher levels, it may make sense to start trimming credit risk in favor of some higher-quality fixed income alternatives or multi-sector strategies.
Loan funds have been very popular, with record inflows of $63 billion in 2013. Is that market in danger of overheating?
The loan market has seen 87 straight weeks of inflows, and we’d attribute that to two key factors. First, investors came to the conclusion last year that rates were going to rise, and they wanted some exposure to floating rate assets with a high coupon. Second is simple volatility. Loans had less than one-third the volatility of either investment-grade or high yield bonds in 2013. Even when rates were falling, we saw flows remain very strong.
So, investors found it very hard to predict where rates might go and, therefore, the appeal of credit exposure increased while the appeal of pure duration decreased. And the fundamentals supported that move. Both loan spreads and credit fundamentals remained decent throughout the year. Investors had good reason to feel they were being well paid for taking on credit risk. We don’t see that changing much in 2014 and, as such, we think the attractive proposition in loans remains intact.
*See below for represented indexes.
How do you assess high yield bonds vs. loans when making investment decisions?
In portfolios where we can own both high yield bonds and loans, it’s really not a question of which to choose. They serve different purposes in the portfolio. When assessing the risk/reward in bank loans, we tend to think of them vs. investment-grade credit, sort of the crossover part of the high yield market. By investing in bank loans, you’re investing in a senior secured asset. Although it may be below investment grade, it’s senior secured, it’s floating rate and that means it’s subject to less duration and less potential for true loss of capital. Like a mortgage, which has a first lien on a house, a bank loan usually gets a first lien on the property, plant and equipment of a company. Therefore, in the U.S. and most bankruptcy processes around the world, you have a secured claim on those assets. So, your real loss, even in a liquidation, is minimal. The average historical recovery on a loan is between 75 and 85 cents on the dollar. Default rates are between 1.5% and 2% because the credit quality is so high right now.
In the current environment, we think floating rate bank loans are a good place to be relative to some other fixed income assets. At a minimum, we can expect to get paid our coupon. That may not sound like the most exciting upshot, but making a positive real return in a rising rate environment looks very good. Some other high yield or investment-grade debt has a negative return outlook given the potential for rising interest rates.
What is your approach in your loan-only portfolios?
We like to remind investors that loans are safety first. Since loans can be repaid at par at any time, they tend to trade there most of the time. As such, the best you’re going to do in most cases is get paid your coupon plus your principal. The worst you can do is take a credit loss. So, priority No. 1 for us: We want to avoid losing money. That means digging deep into each credit, avoiding riskier and less liquid loans and, most importantly, saying “no” to bad deals. Lending is about avoiding pitfalls and consistently getting it right. It requires the knowledge and courage to walk away from deals that don’t help a portfolio or may not work out in the long run. Our experience tells us that the fewer bad deals you do, the better you do.
Loans are not equities, and we don’t pretend they are. Our primary goal is to protect our clients’ money while targeting an attractive coupon yield. We believe it provides for a more consistent experience across time that can allow for outperformance over the long run. We much prefer that versus winning one year and losing the next.
Tell us how you go about doing that.
First, and this applies in the case of both high yield bonds and loans, we employ a bottom-up approach—that’s single-name, idiosyncratic analysis—using a highly rated analyst team. We comb through every credit, every management team, structure and covenant. Second, and importantly, we benefit from being here at BlackRock, the largest investment manager in the world and the biggest counterparty to the underwriters. This affords us a certain respect when it comes to allocations in deals. So while we make our choices individually, our ability to access those choices is unmatched. We honestly believe that when you take a world-class analyst team and you put it within the ecosystem of the world’s largest money manager, and leading risk manager, you have something very special.
What is the role of high yield bonds and loans in an investor’s portfolio today?
High yield bonds continue to represent a good source of incremental income. In an improving economy characterized by company strength, we continue to believe they deserve a core position in investor portfolios. High yield is a good fixed income diversifier because, directionally, it tends to follow equities more so than other fixed income assets. That’s because both equities and high yield bonds are inherently tied to company health: equities in companies’ ability to grow earnings or dividends, and high yield in companies’ ability to pay back debt. So, what’s good for equities is good for high yield; and what’s bad for one is bad for both. Notably, high yield traditionally has traded with about 60% the volatility of equities.
For their part, loans represent a stable source of income that is not interest-rate sensitive like most other fixed income instruments. They provide a high level of income based on credit spreads, with floating rate exposure to rates that helps preserve their value. This is different from fixed-rate instruments, which makes loans a diversifier for fixed income and an instrument not beholden to what the Fed decides to do to the Treasury curve. In the past, people might have looked at loans as an alternative. Today, more often than not, loans are considered a core investment.
*See below for represented indexes.
Any final thoughts for investors?
High yield markets, both bonds and loans, are complex. Not only are you dealing with the inherent credit risk (risk of default and loss of principal and income), but also idiosyncratic sector-, issuer- and credit-specific considerations that can make or break a portfolio. There is a lot of opportunity, but it’s not possible to choose an index and expect a slam dunk. Individual credit research and good risk management are critical. And because this year is not going to be exactly like the last few, extra vigilance is extremely important. A year from now, the relative value is likely to shift somewhat, and investors should be cognizant of that and prepared to adjust their allocations.
The beauty of owning a professionally managed high yield product is that we take on that burden for the investor. Here at BlackRock, we are very dynamic across the economic cycle and the credit cycle. We’re seeking the best risk-adjusted returns and we’re very specific about what we own. When risk is appropriately priced in the market, we will go down in quality and buy it. When it’s not, we will become very defensive. This has allowed us to provide more consistent results for our clients over time. And it’s personal. We put our money where our mouth is. Every member of our team invests in our funds. We’re stakeholders, just like our investors. We think that really speaks to our conviction in the asset class, and particularly to our approach to investing in it.
Bond values fluctuate in price so the value of your investment can go down depending on market conditions. The two main risks related to fixed income investing are interest-rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Commercial banks and other financial institutions or institutional investors make corporate loans to companies that need capital to grow or restructure. Borrowers generally pay interest on corporate loans at rates that change in response to changes in market interest rates such as the London Interbank Offered Rate (“LIBOR”) or the prime rates of U.S. banks. As a result, the value of corporate loan investments is generally less exposed to the adverse effects of shifts in market interest rates than investments that pay a fixed rate of interest. The market for corporate loans may be subject to irregular trading activity, wide bid/ask spreads and extended trade settlement periods. Investments in non-investment-grade debt securities (high yield or “junk” bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories.
* Treasuries represented by the Barclays U.S. Treasury Index; MBS by the Barclays Agency Fixed Rate MBS Index; Inv-Grade Bonds by the Barclays U.S. Aggregate Index; Inv-Grade Corps by the Barclays U.S. Corporate Investment Grade Index; Munis by the Barclays Municipal Index; U.S. Gov. Bonds by the Barclays U.S. Government Bond Index; EM Bonds by the JP Morgan Emerging Market Bond Index Global; High Yield Bonds by the Barclays U.S. Corporate High Yield Index; Bank Loans by the S&P Leveraged Loan Index; U.S. Equity by the S&P 500 Index; Intl Equity by the MSCI EAFE Index; EM Equity by the MSCI Emerging Markets Index; Commodities by the Dow Jones-UBS Commodity Index; Cash by the Merrill Lynch 0-3 Month UST Bill Index. Treasury Bills are the 3-month U.S. Treasury. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the portfolio managers profiled as of March 2014, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that, in certain respects, may not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks.
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