Higher-Quality High Yield Asset Allocations:

Transcription

1 Higher-Quality High Yield Asset Allocations: Achieving Income Objectives Through a Risk-Managed Approach By John P. Calamos, Sr. CEO and Global Co-CIO of Calamos Investments The search for income used to be fairly straightforward. Now, however, low interest rates and a flight to quality have driven down the yields of government bonds, and other segments of the bond market have lost much of their appeal. Meanwhile, a muted economic recovery demands that income-oriented investors, particularly conservative ones, maintain caution about the highest yielding, most speculative bonds. These converging influences make the case for utilizing a higher-quality high yield strategy to diversify and increase the income potential of a core fixed income allocation, and to reduce the credit risk of a lower-grade high yield allocation. Within the high yield market, we see compelling pockets of strength, supported by improving fundamentals and attractive valuations. In an environment where slower global growth and low yields are likely to persist for the foreseeable future, we believe that mid-grade credits offer investors a more risk-appropriate approach to competitive income.

2 TABLE OF CONTENTS INTRODUCTION 3 COMPELLING FUNDAMENTALS IN THE HIGH YIELD MARKET 4 THE CALAMOS APPROACH TO HIGHER-QUALITY HIGH INCOME 6 CONCLUSION 7 The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. High yield securities and unrated securities of similar credit quality (commonly known as junk bonds ) are subject to greater levels of credit (the likelihood of credit downgrade or default on payments) and liquidity risks. High yield securities are considered primarily speculative with respect to the issuer s continuing ability to make principal and interest payments. 2 HIGHER-QUALITY HIGH YIELD ASSET ALLOCATIONS

3 I. Introduction Since 28, nearly every major bond market, including the high yield market, has advanced as investors search for income. But given the low rates globally and the uneven pace of economic recovery, investors are facing growing challenges in their quest for yield. We expect these challenges will only become more widespread. The ranks of income-oriented investors are growing rapidly as aging populations in developed markets are living longer. These global demographic trends further underscore the need for strategies that not only provide competitive income in a lowrate environment but that also reflect a range of risk management considerations, from company-specific default risk to the broader threat of rising rates. Globally, risk-averse investors have moved money out of equities and into bonds, with government and government-related bonds garnering the most interest. This flight to perceived safety, paired with central banks aggressive interest rate policies, has driven yields on government bonds to historic lows. The impact has been so significant that short-term U.S. Treasury securities offer yields of essentially zero percent, while government bonds from other perceived safe havens (for example, Germany and Switzerland) provide negative yields. This has led many income investors to revisit their asset allocations and look for new opportunities. For traditionally conservative income-oriented investors, the high yield market may represent uncharted territory. Many may have preconceived notions about the high yield market, reflecting headline events from decades past. Compared with investment-grade securities, it s true that high yield securities do entail greater default and credit risks in exchange for their higher income potential. However, we believe that active management FIGURE 1. HIGH YIELD SECURITIES HAVE ADVANCED THROUGH MANY ECONOMIC ENVIRONMENTS CALENDAR YEAR RETURNS (%), CREDIT SUISSE HIGH YIELD INDEX 6% 5% 4% 3% 2% 1% % -1% -2% -3% -4% Source: Mellon Analytical Solutions LLC. The Credit Suisse High Yield Index is considered generally representative of the U.S. high yield market. Indexes are unmanaged and do not carry fees or expenses. It is not possible to invest in an index. SEPTEMBER 212 3

4 and rigorous bottom up research can position us well to differentiate among securities and identify those with the most attractive risk/reward characteristics. Although we see compelling opportunities, we believe that the high yield market requires an active, selective approach. For example, the incremental yield gained from stepping too far down in quality is often not DEFAULT RATE Diversification into high yield securities can help boost a portfolio s income potential, and also may mitigate other types of risks. Moreover, the high yield market as a whole has posted positive performance in 22 of 26 years from 1986 to 211 (Figure 1). While past performance does not guarantee future results, this indicates that historically, high yield securities have advanced in a variety of market and economic environments. Additionally, as we will discuss, diversification into high yield securities may not only help boost a portfolio s income potential, but may mitigate other types of risks. FIGURE 2. LOW DEFAULTS, ATTRACTIVE CREDIT SPREADS 16% 14% 12% 1% 8% 6% 4% 2% 25-year average = 4.2% 22-year average = 593bp % DEC '88 DEC '92 DEC '96 DEC ' DEC '4 DEC '8 DEC '12 High-yield default rate High-yield spreads 721bp High-yield defaults 2.21% Source: JP Morgan. High-Yield Bond and Leveraged Loan Market Update, June 212. High-yield yield SPREAD TO WORST commensurate with the risk. This dynamic underscores the need for risk-managed, high income strategies. II. Compelling Fundamentals in the High Yield Market Several factors support our constructive view of the asset class today. Credit spreads are attractive and compare favorably with defaults. Over the long-term, higher credit spreads are reflective of higher risk. But as Figure 2 demonstrates, credit spreads are marginally higher than average, but the default rate is well below average. Research by JP Morgan shows that the ratio of credit spreads to default rates is actually three times higher than the long-term median, indicating that overall, investors are being compensated for default risk in the high yield market. However, as we will discuss at greater length, we do not believe that this compensation is uniformly appropriate across the credit spectrum. Credit fundamentals have strengthened, but the prices of many high yield bonds don t yet reflect these improvements. Not only have default rates been below average (Figure 2), but corporate credits have fundamentally improved since the credit crisis, driven primarily by three factors that we see continuing. 4 HIGHER-QUALITY HIGH YIELD ASSET ALLOCATIONS

5 FIGURE 3. HIGH YIELD ISSUERS HAVE PUSHED THEIR DEBT MATURITIES OUT MATURITY WALL, START OF $ bn or later LTM DEBT/EBITDA FIGURE 4. LEVERAGE OF HIGH YIELD ISSUERS 5.5x 5.3x 5.1x 4.9x 4.7x 4.5x 4.3x 4.1x 3.9x 3.7x 3.5x 4.2x 4.3x 4.2x 4.4x 4.7x 4.8x 5.2x 5.x 4.7x 1Q8 2Q8 3Q8 4Q8 1Q9 2Q9 3Q9 4Q9 1Q1 2Q1 3Q1 4Q1 1Q11 2Q11 3Q11 4Q11 1Q12 4.3x 4.2x 4.1x 4.x 4.x 3.9x 3.9x 3.9x MATURITY WALL, CURRENT (JUNE 212) Source: JP Morgan $ bn Source: JP Morgan. High-Yield Bond and Leveraged Loan Market Update, June A low interest-rate environment has spurred refinancing of corporate debt on a massive scale. In addition to reducing the cost of borrowing, this has also allowed companies to extend debt maturities and reduce near-term financing needs. Figure 3 illustrates this migration of maturities. 2. This refinancing, along with strong operating performance, has led to significantly improved credit metrics for many high yield credits. As Figure 4 illustrates, leverage for high yield issuers has declined substantially since peaking in 29. While leverage ratios are only part of the story, they are one factor we consider as part of our comprehensive ongoing research or later 3. Although economic growth since 28 has been modest, corporate revenues are now back to pre-crisis levels. Of course, the individual credit characteristics of companies vary; but on the whole, we believe that many high yield issuers are equipped to cover interest and capital expenses. Issuance trends are encouraging. Although high yield issuance dipped in the immediate wake of the credit crisis, it has come back strong. Low interest rates and economic recovery in the U.S. have helped support a surge in high yield issuance since the recent low in 28. Issuance through August 212 is $22 billion, compared with $246 billion for all of 211 and a record $32 billion in 21, according to JP Morgan. In contrast, the net supply of some fixed-income spread products, such as asset-backed securities and mortgage-backed securities once a mainstay for more conservative income-oriented investors have dwindled amid persistent uncertainties about homeowner defaults, SEPTEMBER 212 5

6 FIGURE 5. HIGH YIELD BOND PERFORMANCE DURING AND COMING OUT OF RECESSIONS FIGURE 6. A MODEST RISE IN RATES COULD HAVE A SIGNIFICANT IMPACT CALENDAR YEAR RETURN % 6 Credit Suisse High Yield S&P 5 HYPOTHETICAL IMPACT OF RATE FLUCTUATIONS ON BOND VALUE 5-Year U.S. Treasury 1-Year U.S. Treasury regulations and legislation, and the housing market as a whole Source: Mellon Analytical Solutions LLC and Bloomberg LP. The S&P 5 Index is an unmanaged index considered generally representative of the market for U.S. large-capitalization stocks Historically, high yield securities have performed relatively well during and coming out of recessions. Figure 5 shows that high yield bonds often outperformed equities during such periods High Yield Securities: Less Vulnerable to Rising Rates. Over recent years, we have seen monetary policies of extreme accommodation from central banks around the world. However, this level of support cannot continue into perpetuity. Although we cannot predict when a turn will occur, investors must be prepared for interest rates to move upward and potentially with little warning. While the general consensus is that a rapid rise is not likely over the near term, even a modest move in rates could have a major impact on low-yielding Treasurys and other high-quality fixed income assets (Figure 6). 211 % CHANGE IN BOND VALUE (HYPOTHETICAL) % Source: Calamos Advisors LLC. This graph is hypothetical and meant to illustrate general themes. The performance of a bond may be influenced by a variety of factors beyond interest rates. III. The Calamos Approach to Higher-Quality High Income Active management and comprehensive fundamental credit research are particularly important in the high yield sector. Although we see improving fundamentals in the high yield market, the uneven and slower global economic recovery require a higher degree of care in the portfolio construction process. This is not an environment where all companies will do equally well. Yield considerations must be weighed against potential risks, most notably, default risk. While defaults are currently low, they do occur; and a short-term boost in income cannot make up for the longer term problems that come with a default. INTEREST RATE FLUCTUATION +3% As investment managers, our goal is to avoid defaults altogether, while still providing highly competitive levels of income. In our experience, mid-grade credits offer a compelling balance of risk versus return. Historically, mid- 6 HIGHER-QUALITY HIGH YIELD ASSET ALLOCATIONS

7 FIGURE 7. IN PERIODS OF SLOWER GROWTH, MID-GRADE BONDS HAVE OUTPERFORMED SPECULATIVE ISSUES 6% 4% 2% % -2% -4% -6% -8% -1% -12% <(1.5%) (1.5%) to (.5%) (.5%) to.5%.5% to 1.5% 1.5% to 2.5% 2.5% to 3.5% BB B CCC >3.5% Source: Barclays Capital, Bradley Rogoff, CFA, High Yield Bonds and Leveraged Loans, February 212. and subjects it to unnecessary downside risk. We do not try to own every security that the benchmark owns, particularly those rated CCC or below, even if this means our strategy s yield is below the benchmark at times. Additionally, although mid-grade corporate bonds are generally less sensitive to interest rate increases, we still manage duration carefully as a way to potentially mitigate vulnerability to an increase in rates, even a relatively modest uptick. grade issues have outperformed the most speculative credits in periods of slower GDP growth, as shown in Figure 7. Mid-grade credits offer a compelling balance of risk versus return. Our higher-quality approach to high income contrasts with many other high yield managers. We look for improving companies that still offer an attractive yield. We emphasize companies with reliable debt servicing, capable management and a potential catalyst that could lead to a credit upgrade. We are interested in companies with high return on invested capital. In order to understand the pressures a company could come under, we value businesses in the downward phase of the credit cycle. We typically avoid complex business models, workouts and the most speculative credits. In our view, owning the weakest credits simply to pursue the highest yield makes a portfolio too reliant on robust economic growth IV. Conclusion We believe a strong case can be made for a higherquality high yield allocation. Investors need attractive levels of income but a degree of comfort that their principal is reasonably secure. In our view, mid-grade credits are best positioned to meet these requirements in the current environment. The yield is attractive on a standalone basis. We believe the market pricing does not yet reflect the level of fundamental credit improvement that has occurred, leading to compelling valuations from a capital gain perspective. Additionally, when we consider both optimistic and pessimistic scenarios, midgrade credits offer real yield while limiting interest rate risk and credit risk, helping investors move toward their income goals in a low-rate environment. SEPTEMBER 212 7

8 ABOUT THE AUTHOR John P. Calamos, Sr. is chairman, chief executive officer and co-chief investment officer of the firm he founded in 1977, which he took public as Calamos Asset Management in 24 (Nasdaq: CLMS). A recognized authority on convertible securities, he has pioneered investment strategies and techniques to help manage risk for major institutional and individual investors for more than 3 years. Mr. Calamos received his undergraduate degree in Economics and M.B.A. in Finance from the Illinois Institute of Technology. He joined the United States Air Force after receiving his undergraduate degree, served as a combat pilot during the Vietnam War and ultimately earned the rank of Major. He has shared his expertise in two books, Convertible Securities: The Latest Instruments, Portfolio Strategies, and Valuation Analysis (McGraw-Hill, 1998) and Investing in Convertible Securities: Your Complete Guide to the Risks and Rewards (Longman Financial Services Publishing, 1988). He has also authored numerous articles in various financial journals and is a frequent guest on national financial networks including CNBC, Bloomberg TV and Fox Business Channel. ABOUT CALAMOS INVESTMENTS Calamos Investments is a globally diversified investment management firm serving the needs of institutional and individual investors for over 35 years. The company s clients include public and private pensions, foundations, endowments, corporations, financial advisors, families and individuals from around the world who have entrusted the firm with $34.2 billion in total assets as of August 31, 212.* Calamos employs more than 5 investment professionals. Calamos offers a range of global investment solutions including equity, fixed-income, convertible and alternatives to work with clients multi asset allocation frameworks and achieve the goals of their investment programs. *Total assets includes assets under management as well as $1.1 billion for which the company provides model portfolio design and oversight. Outside the U.S. this presentation is directed only at professional/sophisticated investors and it is for their exclusive use and information. This document should not be shown to or given to retail investors. Calamos Investments LLC 22 Calamos Court Naperville, IL calamos.com 212 Calamos Investments LLC. All Rights Reserved. Calamos and Calamos Investments are registered trademarks of Calamos Investments LLC. HQHICOM O C Calamos Investments LLP No. 1 Cornhill London, EC3V 3ND, UK Tel: +44 () calamos.com/global