Corporate credit and pensions: the path less trodden

George M Muzinich explains how investing in high yield bonds can offer
pension funds a low governance yet often forgotten route to higher returns

Following the disappointing returns from equities over the decade so far, European institutional investors are increasingly looking to allocate to asset classes that help them meet their return objectives (typically a real return of around 5% per annum) with low volatility. This has led to an increase in assets allocated to alternatives such as hedge funds, commodities and infrastructure.
Although it may be too early to assess the full benefits of alternatives, investing in non-traditional asset classes requires a significant investment in governance to be truly successful.

But in the search for ever more complex diversified sources of return, are investors ignoring some straightforward, low governance opportunities?

We would like to propose a simple, transparent, low gover-nance asset class, with low correlation to traditional assets, which tends to be ignored by European investors for largely spurious reasons.
Over the past 18 years (since 1990), US high yield bonds have delivered real (after inflation) returns of over 6% per annum gross, with volatility of around 5% per annum.

High yield bonds have a high coupon income and relatively short duration. This helps to provide positive returns even in periods of market stress. Since 1990, higher quality US high yield bonds (as measured by the Merrill Lynch US High Yield BB/B Index) have delivered returns in a range between +34.6% and -2.7% each year, with only two negative years (1994 and 2000). So if this is such an attractive asset class, why do so few European institutional investors allocate to high yield?

First of all, a bit of background. Companies borrowing in the bond market usually pay for a credit rating. The rating agencies typically have around 20 different ratings, with everything from AAA down to BBB- (ten rating notches) classified as ‘investment grade’ and everything below this line (also ten rating notches) classified as ‘sub-investment grade’, ‘high yield’ or ‘junk’. The implication is clearly that investment grade bonds are safe, low risk assets but high yield bonds are risky, volatile and to be avoided.

However, things are not that straightforward. The almost arbitrary distinction between investment grade and high yield means that the interest investors can usually earn by investing just below the investment grade cut-off is significantly higher than is justified by the additional risk.

Table 1 shows recent credit spreads for US corporate bonds at various points on the ratings
scale. The credit spread is the additional interest earned by investors above a ‘risk-free rate’, normally the yield on a government bond of equivalent maturity.

What causes this pick up in yields of over 2.5% per annum between BBB and BB rated bonds? In our opinion, it is due to a misunderstanding of risk. The perception that high yield bonds are risky means that many investors insist their managers cannot hold them. Investors owning investment grade bonds that are downgraded to high yield are often forced to sell these bonds at whatever price they can get.

However, the majority of high yield bonds do not default. Default rates for high yield bonds average around 5% per year. High yield bond recoveries average around 40%, so the capital loss on a 5% per annum default rate is an average of 3% per annum.

Vitally, most defaults in the high yield market can be avoided by undertaking fundamental research. As an active high yield manager, Muzinich dedicates significant resources to research. Our US high yield strategy has suffered just a handful of defaults over 18 years, at a cumulative cost in performance terms of less than 0.1% per annum.

Although ratings have proved to be robust in predicting defaults, almost all issuers are downgraded before they default. It stands to reason that a higher percentage of CCC rated bonds default than A rated bonds, because A rated issuers hitting trouble will usually be downgraded to CCC or lower prior to default. However, very often the damage to investors (in the form of falling bond prices) has been done well before a rating starts to slide.

So what do we look for when analysing a high yield bond issuer? We look for companies generating sufficient cashflow to meet liabilities. Credit analysts are not overly concerned with profit, as profit is what is left after debts have been paid. To ensure that each company we invest in has a ‘cushion’, we take a more pessimistic view of cashflows than is necessary. It has been said that a key difference between credit and equity analysts is that credit analysts are pessimists and equity analysts are optimists. We would agree. Saying that, in the ten years to 31 July 2008, global equities (represented by the MSCI World Index in US$) returned just 4.41% a year with 14.48% volatility, whereas our US high yield strategy returned 5.61% with 5.37% volatility. Not bad for a bunch of pessimists managing a pile of junk.

Is now a good time to invest in high yield? In previous periods where spreads reached similar levels to today, returns over subsequent years proved very attractive (see table 2). Since high yield bonds pay high coupons and have a relatively short duration, they should prove resilient in the current environment of higher inflation.

In Europe, we find that fixed income mandates often force managers to sell bonds that are downgraded to sub-investment grade. We also find a strong perception that high yield means high risk. In reality, strategically allocating a proportion of assets to high yield via an experienced active manager should improve overall portfolio returns and reduce volatility. There is little requirement for increased governance since high yield is a simple, transparent and generally liquid asset class.
In conclusion, we see high yield as an ideal strategic asset class for institutions looking for attractive real returns and low volatility. High yield is simple and transparent. It also has low correlation to traditional asset classes and a built-in inefficiency waiting to be exploited by good active managers with the skills to carry out fundamental credit research.

Written by George M. Muzinich, President, Muzinich & Company