ifast insight - schroder high yield

72 February ~ July | 2009

investmentinsightby Stephanie thng

Important: See Disclaimer on Page 6 | iFAST INSIGHT 73

Looking To High Yield Bonds

In 2009

World growth is forecast to fall to its lowest level since World War II,

said the International Monetary Fund (IMF) in its latest World Eco-nomic Outlook (28 January 2009). The IMF added that financial markets “remain under stress” and that “the global economy is taking a sharp turn for the worse”.

In this economic climate, finan-cial markets have taken a severe beating – global equity markets, as represented by the MSCI World Index, have declined by 40.1% on

a year-on-year basis (as at 28 Janu-ary 2009). With the volatility rag-ing in the equity markets, it is little wonder that the majority of inves-tors are shunning equities, flock-ing instead to safer havens such as bonds and US Treasuries.

A safe haven it may be, but US Treasuries are hardly offering the best value for investors currently. At one point in time in December last year, panic among investors drove the yield of 3-month US Treasuries below zero, as investors flocked en masse to the safety of-

image source: stockxpert.com

High yield bonds look set to be one of the outperforming asset classes this year. DaviD Harris, Us Fixed income Portfolio Manager with schroders, tells us more.

Article disclAimer: This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any fund. No investment decision should be taken without first viewing a fund’s prospectus. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. As some of the authors/contributors may have a personal interest in some of the funds commented on, investors should seek the advice of professional advisers regarding the evaluation of any product, unit trust or other financial instruments, report, index, opinion or any other content contained herein, to ensure the investment instrument is suitable for them. In the event that investors choose not to seek advice from a professional adviser, they should consider whether the investment instrument is suitable for them. Past performance and any forecast is not necessarily indicative of the future or likely performance of the fund. The value of units and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. iFAST Financial and/or its licensed financial advisers representatives may own or have positions in the funds of any of the asset management firms or fund houses mentioned or referred to in the article, or any unit trusts or Singapore Government Securities bonds related thereto, and may from time to time add or dispose of, or may be materially interested in any such unit trusts or Singapore Government Securities bonds.


fered by US Treasuries, as a refuge from the extreme volatility in the equity markets. Pundits are pre-dicting that a big bubble is form-ing in US Treasuries, as yields have plunged to the lowest levels in decades. And if the pundits have it right, this bubble looks set to pop anytime.

David Harris, US Fixed Income Portfolio Manager with Schroders, expects the yields on US Treas-uries to remain depressed for the whole of 2009. “US Treasuries are expensive by nearly every measure, (and) are likely to remain expen-sive through the first half of 2009 and possibly through the end of the year. Persistent weak economic conditions, widespread investor risk avoidance and deflationary pressures will contribute to keep-ing Treasury yields low.”

But government actions and the risk of rising inflation should lift the yields of the US Treasur-ies from the doldrums, in 2010 and beyond. “Eventually, we do believe that massive fiscal and monetary stimulus will cause Treasury yields to increase in order to compensate for the risk of higher inflation in 2010 and beyond,” adds David.

Apart from US Treasuries, money has also been flowing to

investment-grade corporate bonds and high yield bonds, which offer better value; but the risks involved are admittedly higher as well. In-vestors with a higher risk appetite could consider adding high yield bonds into their portfolios.

High yield bonds, otherwise known as non-investment grade bonds or junk bonds, refer to bonds with a credit rating of “BB” and below (Standard and Poor’s) or “BB+” and below (Fitch Ratings).

Unknown to many non-investors of global high yield bonds, the glo-bal high yield bond space is largely dominated by issuers domiciled in North America. “There is common perception that the global distribu-tion of high yield issuers is similar to that of government bonds or investment-grade issues. High yield is actually a relatively new fixed in-come sector outside of North Amer-ica, and the US in fact remains the largest source of high yield issuers,” commented David.

In an interview with David, he tells us more about the outlook for high yield bonds in 2009, and why he expects this asset class to be one of the outperforming asset classes this year. He also shares with us the risks faced by investors of high yield bonds this year.

Based in New York, David joined Schroders in 1992, and has more than 20 years of investment experience. David holds an MBA from J.L. Kellogg Graduate School of Management, Northwestern University, as well as a BBA from the University of Massachusetts at Amherst.

iFAST: Based on the factsheet as at end-November 2008, the fund has 78.8% in the United States. What are the reasons behind this? David Harris (DH): The 78.8% figure represents the share of issu-ers domiciled or registered in the US, and compares to 81.1% in the benchmark. The 2.3% under-weight in the US was offset with an overweight in Europe and Asia. The substantial market disarray in late 2008 impacted high yield mar-kets in Europe and Asia dispro-portionally, due to more concen-trated industry exposure and less deep investor demand. The fund is positioned to take advantage of normalisation of spreads in these markets.

iFAST: Against the backdrop of a global recession, the default risks for high-yield bonds would conceivably go up. What is being done to mitigate such risks? ➝


74 February ~ July | 2009

investmentinsightby Stephanie thng


DH: The fund is actively managed with exposures rotated through market sectors, depending upon a combination of our economic out-look, industry/issuer fundamentals and the relative value of opportu-nities across sectors. The fund is positioned defensively with about 14% cash and 4% exposure to in-vestment grade corporate bonds, higher overall credit quality (aver-age BB- compared to B for the in-dex), including 16% underweight in bonds rated below B-, and a sig-nificant bias in favour of cyclically defensive industries.

iFAST: What are the default risks im-plied by the market now? How does this compare with that of past recessions?DH: Implied default rates are no-toriously difficult to estimate as yields imbed assumptions about default expectations and recovery rates as well as a highly volatile risk

premium. The risk premium com-ponent is particularly high now, given increased volatility and un-certainty. To arrive at an implied default rate of 13.7%, we begin with a high yield index spread of 15.94 % as of 9 January, 3.13% for the long term average premium to Treasury bonds, plus an additional 2.50% to reflect the elevated risk premium (assuming 25% recovery rate on defaulted bonds).

This is outlined in the table be-low from J.P. Morgan.

Risk premium is much higher now than in the past several reces-sions, and the implied default rate of 13.7% is higher than the actual default rate experienced during the 2002 or 1991 economic downturns.

iFAST: What is the weighted yield-to-maturity for the fund? DH: As of 13 January, the yield-to-worst* was 12.2%, and was 12.9% as of 31 December 2008. We prefer yield-to-worst as more than 50% of the high yield market is callable and historical evidence suggests the majority will be called. In all cases yield-to-worst will be equal to or less than yield-to-maturity.

*NB: Yield to Worst refers to the lowest potential yield that can be received on a bond without the issuer actually de-faulting. (Source: Investopedia)

iFAST: What kind of returns and volatility can investors expect for 2009?DH: Schroders forecasts the total return on the global high yield in-dex for the remainder of 2009 to be in the range of 8% to 12%, with elevated volatility similar to 2008 throughout the year. Our total re-turn forecast is based on a starting yield of about 13.3% as of 16 Jan-uary 2009, combined with some modest price depreciation due to weak economic fundamentals, ris-ing defaults and investor risk aver-sion.

iFAST: What would be the rationale for investors to buy into high-yield bonds now?DH: Risk premiums are unusually high right now as investors demand a premium for higher uncertainty and default risk. This extra premi-um translates into an overall yield which is high enough to absorb ac-tual defaults and provide a cushion against additional bad economic news, mark-to-market risk and il-liquidity from poor financial con-

➝

HigH-yield spread estimate using a 25% recovery rate and a 250bps liquidity premium

RecoveRY Rate Default Rate Default loss excess spReaD est spReaD pRemium foRecast

(100%-25%) x 8.0% = 600bps + 313bps = 913bps + 250bps = 1163bps

implied HigH yield default rate based on a 25% recovery rate and a 250bps liquidity premium

actual spReaD excess spReaD pRemium Default loss RecoveRY Rate Default Rate

1594bps - 313bps - 250bps = 1031bps / (100%-25%) 0.137

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ditions (for example, dealers not making markets as robust as prior to 2008).

The high yield market has an average bond price of $59.93 and average coupon of 8.0%, resulting in a 13.35% current yield. Divid-ing by the market duration of 4.11 years gives us a break-even yield change of 3.25%. That is, for in-vestors allocating out of cash, the yield on the high yield index could go from 19.75% to 23.0% before it has a negative total return.

iFAST: Do you expect high yield bonds to be one of the outperforming asset classes this year? Why?DH: Yes. Given the elevated start-ing yield compared to other asset classes, high yield is well positioned to outperform most other bond sectors in 2009, including Treasur-ies, agencies and mortgage-backed bonds and cash, and should also handily outperform equities should economic recovery be slow to take hold as we expect.

iFAST: From end-November 2008 till 6 January 2009, high yield bonds went up more than investment-grade bonds (source: FINRA-Bloomberg). What are the reasons behind this phenomenon?DH: Nearly all non-Treasury bond sectors rebounded during this pe-riod. In general, sectors with the most severe underperformance during the second half of 2008 had the best returns in December and the first week of January. We view this as a typical response fol-lowing a sharp market movement. In this case, overall dealer invento-

ries had been significantly reduced and were unable to satisfy alloca-tions into high yield at year end.

Indeed, industry-wide subscrip-tions to high yield mutual funds were sharply positive in the four full weeks in December and the first two weeks of January, at the same time as the positive news of US govern-ment providing financial support for GMAC and Rescap (bonds of both issuers rose more than 100%) created a favourable climate for high yields to perform well. However, significant near-term hurdles for credit remain (economic data, new issue supply), suggesting the rebound will be tem-porary.

iFAST: What are the biggest risks faced by investors of high-yield bond funds this year? DH: We see the rising defaults as the biggest risk to high yield in-vestors in 2009. While Schroders forecasts full year 2009 defaults at about 12%, less than Moody’s latest prediction of 15.1%, the ac-tual number of companies filing for bankruptcy will be daunting. A 12% default rate implies approxi-mately 30 companies per month will default, compared to just 4 to 7 defaults per month in 2008, creat-ing a highly negative environment for investors.

Moreover, forecasts are for de-faults to be clustered in economi-cally sensitive sectors such as re-tailers, auto parts and media, but the risk of negative surprises of defaults in more stable sectors is significantly heightened.

A second large risk comes from another wave of selling by investors

seeking to reduce risk due to mar-gin calls and redemptions, similar to the September through Novem-ber period last year. We see 2009 as the inflection period for high yield; however, we recognize that sig-nificant impediments for sustained recovery remain and that investor sentiment is likely to remain frag-ile and subject to sharp reversals, resulting in elevated volatility for much of the year. iFAST


ifast insight - schroder high yield

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