Where risk pays off: high-yield bonds

In the fall, a high yield bond fund manager had the appeal of a plague bearer, today the asset class is driving stellar returns and attracting money as it comes off record lows. While high yield bonds have gained a lot of ground, one veteran high yield strategist says there’s still opportunity in the space.

Investors haven’t completely missed out on the high yield comeback, says Eric Takaha, director of Franklin Templeton’s California-based corporate and high yield bond investing group. Takaha is in Toronto as a key speaker for the firm’s Investment Outlook and Opportunities Forum.

“We’ve seen valuations go from the trough of the market back in early December when spreads were about 19% to 20% above government bond yields. Today, we’re about 10% above government bond yields. Those spreads have been cut in half and that compression is why the market is up 25% to 30%,” he says. “During the last downturns, in 2002 and 1991, the peak of spreads was about 11% above government bonds. Outside the last six months we’re fairly close to the prior troughs in the marketplace. I say that to give you a sense that although we’ve had a pretty good run on the market from a valuation basis, it still remains on the cheaper side of where it has been in the last 30 years.”

Investors who go into high yield bonds from this point forward are making a call that the downside risk of default on these securities doesn’t outweigh the nice yield they currently offer.

“Back to 2007, when the market was trading at par —100 cents on the dollar — we had a heightened focus on trying to avoid default situations because they would mean significant downside in price,” Takaha says. “[Our selection process] is very similar to stock investing, where we focus on high yield companies. We typically meet with the management teams of these companies and do our write-up. We have our high yield analysts working with our equity analysts because they cover the same industries and in many cases the same companies. Then we construct relative valuations.”

Takaha makes it clear the sector-wide default risk in the shorter term remains high. With prices off their lows, he has to strike a balance in his funds, and make sure he selects bonds with a strong valuation growth potential that isn’t offset by a strong probability of default.

“We take a look at the yield and spread, and that’s where we base our decision on. We get all the ratings information and the sell side research, but for us the final determination comes from our own valuation work relative to the valuation of the credit. There isn’t any one theme, in terms of industry weightings or ratings quality, that we’re focused on. In terms of our view in the marketplace, we’re not looking to be overly aggressive right now given the rally we’ve seen,” he adds. “We think default rates are likely to remain above average for the near term.”

In some cases, Takaha looks at the distressed end of the spectrum to pick up some debt.

For instance, a bond priced at 40 cents on the dollar may have a high level of default risk, but if there’s a good recovery the downside is limited. If that company chooses not to restructure, there’s a significant upside and that may be a good investment opportunity, Takaha explains. “We’ve seen recovery this year — the average high yield bond price is still in the 80-cent range, and if you look at distressed bonds, they’re still trading in the 40, 50 or 60 cents [on the dollar] range.”

High yield investors cannot be singularly focused on defaults — they have to look at the asset class from a total return perspective, he notes.

“You may end up having some defaults in the overall portfolio, but from a return standpoint it doesn’t necessarily mean it’s going to hurt the return [of the portfolio], Takaha says. “In fact, if you look at year-to-date performance, the markets are up 30%, but if you look at the lowest quality bonds — CCC rated — and the defaults, their returns are [still] substantially higher than the overall high-yield market.”

In Takaha’s opinion, it has actually been the higher quality portions of the market that have underperformed, which he says is typical when you see a big rally. “This points out to the fact that the focus isn’t just on avoiding defaults when the valuations are cheap. A lot of the value can be found in the lower quality bonds.”

As companies default and debt financing terms become more restricted, Takaha believes it will eventually create a more stable asset class that provides more predictable sources of yield.

“In 2007, the spread got down below 3%. You had lots of trade in the securities, [particularly] in terms of the wave of leveraged buyouts between 2003 and 2006. Things are likely to be a lot more tepid over the next few years, given that investors aren’t willing to except the same level of leverage,” he says. “A lot of defaults are likely to happen to levered-up companies. It’s in a weak earnings cycle that they aren’t able to meet their obligations, and you see more [fiscal] discipline and less M&A. That probably improves the longer term outlook for credit quality.”

(07/24/09)