Prudential Fixed Income The Sweet Spot of the Bond Market: The Case for High Yield s Upper Tier June 2003 Michael J. Collins, CFA Principal, High Yield Many institutional investors are in search of investment opportunities that can potentially enhance expected returns and/or increase return in a risk-controlled fashion. The prevailing low interest rate environment, combined with tremendous equity volatility and lessthan-compelling equity valuations, has exacerbated this dilemma for plan sponsors and corporate treasurers. High yield bonds offer a solution that has the potential to enhance return while providing diversification to the investor s portfolio. However, some investors may be fearful of credit defaults, volatility and a high correlation with equities. Such investors may be interested to learn that the upper tier of the US high yield market has quietly generated an impressive track record. This higher quality segment of the high yield market has consistently provided investors solid returns with moderate risk in both absolute and risk-adjusted terms. THE CASE FOR BBs BBs Have Historically Outperformed Other Corporate Bond Sectors As the table below illustrates, BB-rated high yield bonds have historically outperformed other corporate bond sectors both investment grade and high yield. The competitive performance vs. investment grade sectors is even more remarkable in light of the fact that high quality interest rates are at 20-year lows while yields on BBs are average. Based on this, BB-rated bonds could be considered the sweet spot of the bond market. High Yield Perspectives For more information contact: Kevin A. Myers Prudential Investment Management 2 Gateway Center, 4th Floor Newark, NJ 072-5096 973.367.4779 Return and Risk Within Corporate Bond Market July 1983 to December 2002 Annualized Return (%) Annualized Std Dev (%) Sharpe Ratio AAA.01 5.48 0.72 AA.18 5.52 0.74 A 9.99 5.50 0.71 BBB.11 5.52 0.73 BB.36 5.72 0.75 B 8.71 7.87 0.33 CCC 4.32 12.69-0.14 Source: Lehman Brothers Corporate Indices
Taking Incremental Risk Within High Yield Doesn t Pay High yield is a paradoxical sector in that investors have not been paid over the long term for taking incremental risk. Because of the asymmetrical nature of corporate bond returns, as well as the particular susceptibility of high yield bonds to defaults, the traditional upside-downside relationship has not worked in the favor of high yield investors. In the high yield market, higher yielding securities have ultimately produced the lowest returns, due to the high incidence of principal-eroding defaults. In contrast, the lowest yielding securities have actually re-paid their principal often enough to more than overcome their ex ante yield disadvantage. For example, over the past 19 years, CCC-rated bonds have returned only 4.3% while BB rated bonds have provided a return of.4% with much less volatility. While this strikingly unusual historical risk/return relationship may imply that the high yield market is inefficient, there is some theoretical justification for this imbalance (see page 5). Annualized Returns (%) 12 8 6 4 BB Return and Risk Within High Yield July 1983 to December 2002 B 2 5 6 7 8 9 11 12 13 Volatility* (%) Of course, over short time horizons, particularly during bull markets in high yield, the lower quality tiers of high yield will outperform on a total return basis. We have experienced this phenomenon again recently, as CCCs have outperformed since the autumn of 2002. But, on a riskadjusted basis, BBs are still compelling. To forego the high volatility exhibited by CCCs, many fixed income investors would be satisfied with the lower double digit returns provided by BBs. CCC Annualized Returns (%) 45 40 35 30 25 20 15 2 BB Return and Risk Within High Yield January 31, 1991 to December 31, 1993 B CCC 4 6 8 12 14 Volatility* (%) Annualized Annualized Return/Risk Sharpe Return (%) Std Dev (%) Ratio Ratio BB 17.53 3.27 5.36 3.99 B 24.75 6.60 3.75 3.07 CCC 39.26 12.61 3.11 2.76 2 *Annualized standard deviation of monthly returns
A Credit-Risk-Neutral Analysis Further Supports BB s Underlying Value A more rigorous analysis further underscores the inherent value in the upper tier of high yield. Even on a purely credit-risk-adjusted basis versus US Treasuries, the BB sector of the high yield market has historically outperformed the market s expectations. By comparing the excess return over Treasuries, BB-rated corporates outperformed both investment grade and B-rated bonds from 1989 to present. Historical Excess Return and Standard Deviation vs. US Treasuries January 1989 to December 2002 BB Corp Inv Grade Corp B Corp Annualized Excess Return (%) 2.47 0.42 1.67 Annualized Standard Deviation (%) 5.36 2.02 8.36 Information Ratio 0.46 0.21 0.20 The relative outperformance of BB-rated corporates over investment grade and B-rated corporates varies significantly over time. This variation is due to an effect of the credit cycle: BB-rated corporates have a tendency to outperform investment grade corporates (but not B-rated corporates) in bullish environments and outperform B-rated corporates (but not investment grade) in bearish ones. 20 15 Bearish Historical Rolling 12-Month Excess Returns Bullish Bearish Bullish Bearish Percent 5 0-5 - -15 BB minus B BB minus IG -20 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 To adjust for this credit cycle effect, we examined the performance of BB-rated corporates versus a barbell portfolio made up of the B-rated corporates and investment grade corporates. The investment grade and B-rated corporates were weighted so that the portfolio had the same credit cycle sensitivity as BB-rated corporates. We estimated the weights for the full period (1/89-12/02) of the barbell portfolio to be 57% investment grade and 43% B-rated corporates. 3
As shown below, for most of the historical period, with the notable exception of the most recent months of 2002, BB-rated corporates outperformed the weighted portfolio of investment grade and B-rated corporates. The underperformance of BB-rated bonds in the middle of 2002 was largely due to the precipitous decline of newly fallen angels, particularly WorldCom, which was rated BB for a very brief time. Historical Excess Return and Standard Deviation BB minus Barbell (of Investment Grade & B-Rated) January 1989 to December 2002 BB minus BB Corp Inv Grade B Corp Barbell Annualized Excess Return (%) 2.47 0.42 1.67 1.52 Annualized Standard Deviation (%) 5.36 2.02 8.36 2.58 Sharpe Ratio 0.46 0.21 0.20 0.59 Weights in Barbell 1.00-0.57-0.43 Historical Rolling 12-Month Excess Returns BB minus Barbell (of Investment Grade & B-Rated) 8 6 Percent 4 2 0-2 -4-6 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 4
What Are the Fundamental Drivers of BB Outperformance? The empirical results are compelling. We offer our theses regarding the fundamental market behavior and trends that may be driving the BB-rated corporate outperformance: 1. A Lack of Natural Buyers Investment grade portfolio managers generally may be constrained from purchasing BB-rated corporates because of investment guideline restrictions on high yield securities or insurance company risk capital regulations. On the other hand, typical high yield mutual funds, which have traditionally been sold on yield, may not find BB-rated corporates as attractive as B-rated corporates due to their lower yield levels. This lack of natural buyers for BB-rated corporate bonds generates a tendency for BB-rated corporates to be undervalued and, therefore, to outperform. 2. Fallen Angel Effect This market segmentation among buyers exaggerates the effect of a downgrade from investment grade to BB. If an investment grade bond is downgraded to BB, investment grade portfolio managers often must sell the bond. Further, they must sell into a relatively small high yield market, resulting in a very attractive price to the limited number of buyers. This effect is exacerbated by the typically large amount of debt entering the high yield market. Alternatively, BB-rated corporates that experience credit improvement or benefit via mergers and acquisitions activity can experience considerable price improvement upon upgrade to investment grade. 3. Positive Credit Migration BBs have historically experienced more favorable credit migration trends than other corporate quality sectors. Other quality tiers have experienced a greater proportion of downgrades to upgrades. Perhaps one reason for this anomaly is the significant reduction in interest expense for issuers upon becoming investment grade. Companies that are just below investment grade are therefore motivated to improve their credit standing. Positive merger and acquisition activity (e.g. being taken over by an investment grade company) has also disproportionately benefited BB-rated companies in the past. 4. Lower Default Rates BBs have also experienced much lower default rates than the other high yield quality tiers, and in some cases, such as in 2002, the BB default rate has been nearly the same as the BBB default rate. Percent of Issues Defaulted 30 25 20 15 5 Average Annual Default Rates Average Default Rate (1980-2002) 2002 Default Rate 0 Baa Source: Moody s Ba B Credit Rating Caa-C 5
IS NOW A REASONABLE TIME TO CONSIDER SUCH A STRATEGY? Low Treasury Yields May Be Here to Stay Obviously, US Treasuries provide (ultimate) safety of principal and generally offer excellent diversification away from risky asset classes such as equities. However, the 20-year bull market in government bonds both in the US and most developed overseas markets has left global government bond yields at historic lows and prospective returns largely unattractive. In fact, several ingrained long run demographic trends (e.g. the aging of developed country populations) favor a low interest rate environment for many years to come. 11 -Year US Government Bond Yields 9 Percent 8 7 6 5 4 3 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Source: Bloomberg. While High Yield Spreads are Still Wide by Historical Standards Despite the recent narrowing in corporate credit spreads, the situation in the corporate credit sectors of the fixed income market is largely the mirror image of that in the Treasury market. Certain investment grade corporate bonds, many high yield corporate bonds, and even select emerging market debt securities still offer generous yields, particularly in relation to their much richer government bond brethren. Indeed, the volatile credit environment over the past several years has caused yield spreads and yield ratios on high yield bonds to remain at historically wide levels. 550 500 450 Corporate Yields as a Percent of Treasury Yield HY YTW Ba YTW Percent 400 350 300 250 200 150 0 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Source: Lehman Brothers, Bloomberg and Prudential Investment Management internal calculations 6
PUTTING THESE OBSERVATIONS TO USE IN YOUR PORTFOLIO BBs Can Provide Diversification The high yield market marches to the beat of its own drum. It is not highly correlated with other asset classes over long periods, (but, of course, exhibits varying degrees of correlation with equities and high grade fixed income securities at different points in time). BBs are ideal for traditional investors who desire incremental returns but want to limit the equity-like behavior (i.e. volatility) of their portfolios. Moreover, relative to the middle and lower quality tiers of the high yield market, BB-rated bonds will behave more like fixed income securities. Correlation Matrix 1983 to Present Lehman Lehman BB B CCC S&P 500 Agg Index HY Index Corp Corp Corp Index Lehman Agg Index 0% 37% 51% 34% 13% 24% Lehman HY Index 0 90 98 87 51 BB Corp 0 85 69 52 B Corp 0 84 50 CCC Corp 0 40 S&P 500 Index 0 Source: Lehman Brothers, Bloomberg, Prudential Investment Management internal calculations Which Leads to Lower Overall Portfolio Volatility From a portfolio structuring perspective, high yield is an excellent diversifier. It can increase returns and decrease risk, or volatility. This holds true when adding BBs to a high grade fixed income portfolio or to a traditional portfolio of high grade bonds and equities..00 Risk and Return of an Investment Grade Portfolio with BBs 1983 to Present Average Annualized Portfolio Return (%) 9.90 9.80 9.70 9.60 35% BB, 65% Agg. 30% BB, 70% Agg. 40% BB, 60% Agg. 25% BB, 75% Agg. 20% BB, 80% Agg. 45% BB, 55% Agg. 15% BB, 85% Agg. 50% BB, 50% Agg. % BB, 90% Agg. 5% BB, 95% Agg. 0% Agg. 9.50 4.35 4.40 4.45 4.50 4.55 4.60 4.65 4.70 Portfolio Volatility* (%) Source: Lehman Brothers, Bloomberg, Prudential Investment Management internal calculations *Annualized standard deviation of monthly returns 7
For example, if we add increasing amounts of BB-rated bonds to a Lehman Aggregate bond portfolio, we find that returns increase, while portfolio volatility decreases. The minimum volatility mix of 70% Lehman Aggregate and 30% BB-rated bonds provides a return 21 basis points higher than the 0% Lehman Aggregate portfolio with lower volatility. Summary In many regards, the upper tier of the high yield market BB-rated and quality B-rated bonds may be a solution to plan sponsors looking to enhance return with a reasonable risk trade-off. As we have demonstrated, BB-rated bonds may be the sweet spot of the corporate bond market. They have historically offered attractive returns with a modest amount of volatility, income with few defaults, and a diversification benefit via their moderate correlations with other asset classes. The author wishes to recognize Yves Trinquet, Kathy Chang and Alyssa Davis for their contributions to the quantitative analysis used as a basis for this article. Copyright 2003, Prudential Investment Management, Inc. Prudential Financial is a service mark of The Prudential Insurance Company of America, Newark, NJ and its affiliates. Prudential Investment Management, Inc., a registered investment adviser and a Prudential Financial company. The comments, opinions and estimates contained herein are based on or derived from publicly available information from sources that Prudential Investment Management believes to be reliable. We do not guarantee their accuracy. This material, which is for informational purposes only, sets forth our views as of this date. The underlying assumptions and these views are subject to change. Past performance is not indicative of future results. The information and opinions herein re not to be construed as an offer to sell or the solicitation of an offer to buy any security or security type. PIM20030128-24