HEALTH WEALTH CAREER THE EVOLUTION AND BENEFITS OF GLOBAL HIGH YIELD AUGUST 2017
2 The development of global high yield has been decades in the making. High yield, once a market decidedly dominated by US issuance, now consists of issuers from across the globe. Investors looking for better diversification and enhanced alpha opportunities should consider a global approach when allocating to high yield.
INTRODUCTION Most investors understand global high yield to be a blend of below-investment-grade-rated corporate bonds from the US, Europe and emerging markets. Some asset managers and investors prefer a developed-market approach, which consists of highyield bonds from only the US and Europe. Though this has its merits, our view is that a portfolio consisting of all three regions provides the best opportunities for risk-adjusted returns. However, investors already allocating specifically to emerging market debt (EMD) might find a developed-market-only approach would suit their requirements better. The characteristics of the global, emerging markets, US and European high-yield markets are shown in Figure 1. Global and US high-yield markets are comparable, which is to be expected given US high-yield bonds make up the majority of the market value. The index composition of European and emerging market high yield differs from the US. Both Europe and emerging market high yield possess slightly higher credit quality, as well as a lower overall duration. There are several index providers that can provide an adequate benchmark for global high yield. The broadest and most representative index we have found for global high yield is Merrill Lynch s Global High Yield Index (Bloomberg ticker HWOO). This consists of below-investment-grade corporate issuance from the US, Europe, Canada and emerging market countries. The global high-yield market has grown significantly over the past 10 years: its total face value as of December 31, 2006 was under $1 trillion: as of December 31, 2016, its total face value was $2.1 trillion. Although US issuers still dominate the market, European and emerging markets high-yield issuance is growing at a faster clip, and is expected to comprise a growing proportion of the market in years to come. FIGURE 1. GLOBAL HIGH YIELD CHARACTERISTICS AS OF DECEMBER 31, 2016 Global US European Emerging market Number of issues 3,145 1,949 620 624 Full market value (USD billion) 2,075 1,314 376 389 Maturity/WAL (years) 6.06 6.36 4.91 6.05 Effective yield (%) 5.86 6.19 3.63 7.03 Effective duration (years) 4.03 4.25 3.4 3.83 OAS (basis points) 436 422 390 537 Quality B1 B1 BB3 BB3 1
HISTORY OF HIGH YIELD For most of the twentieth century, new issue bonds in the US were investment-grade rated, and the only publically traded high-yield bonds were the so-called fallen angels companies that had lost their new issue investment-grade rating and had been subsequently downgraded to junk. This changed in the 1980s with the rise of Drexel Burnham Lambert and its star trader Michael Milken, who recognized the importance of providing financing for companies that were frozen out of the bond market and forced to finance themselves through bank debt or equity. Shrewd investors saw the value in owning high-yield bonds, which often provided superior risk-adjusted returns compared with traditional investmentgrade bonds. The growth of global high yield over the past 10 years has been significant (see Figure 2). The European high-yield market achieved a notable market presence after the adoption of the euro in the early 2000s, although at that time a high percentage of the market value was concentrated in the technology, media and telecommunications sectors. Emerging market corporate bond issuance has also grown materially as it evolved from a relatively volatile asset class to one supported by improved credit quality and political stability. The global high-yield market doubled over the past 10 years FIGURE 2. GROWTH OF GLOBAL HIGH YIELD 2.5 FACE VALUE (USD MILLIONS) FACE VALUE (USD MILLIONS) 2 1.5 1 0.5 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Emerging market European US Source: Merrill Lynch Percent of Index 2006 2011 2016 US high yield 68% 68% 63% European high yield 14% 17% 17% Emerging markets high yield 8% 13% 20% 2 Source: Bloomberg
ADVANTAGES OF GLOBAL HIGH YIELD The two main reasons for putting in place a global highyield portfolio rather than a traditional stand-alone US or European high-yield portfolio are improved credit diversification and increased alpha opportunities. Being able to source investment opportunities tactically across US, European and emerging market high yield allows for more alpha potential. Managers are able to exploit mispricing and relative value opportunities when allowed to look across a broader set of bonds with various duration, credit, sector, country and currency characteristics. For non-us investors, the diversification advantages should be amplified because of the less diverse selection of corporate high-yield issuance in their own capital markets. US investors are typically able to gain adequate sector and issuer diversification in the US high-yield market, especially considering that the face value of US high yield has approximately doubled over the past decade. However, allocating across the globe allows for more sector diversification. In each respective region, high yield has been known to possess high issuer concentration, although this has been improving with time. For example, the largest sector in European high yield is financials, whereas the largest sector in US high yield is energy. A global allocation can possibly mitigate the total drawdowns when individual sectors such as these sell off, as happened during the 2008 financial crisis and the 2014/2015 fall in commodity prices. Global high-yield bonds improve credit diversification and increase alpha opportunities 3
PORTFOLIO CONSTRUCTION IN GLOBAL HIGH YIELD Managers typically have two approaches to managing a global high-yield portfolio: the sleeved and the unified methods. The sleeved method has separate US, European and emerging markets portfolio managers managing their portfolios independent of each other, and then working together to determine the most appropriate weighting across the regions. The advantages of this include regional portfolio managers focusing on the market and sector in which they possess the most expertise. However, possible drawbacks are that each manager s incentives may not be properly aligned, and they could be more focused on the performance of their individual sleeve rather than the overall portfolio. Under the unified method, the portfolio managers will choose bonds across regions, ensuring a holistic view of the global market. The drawback to this is that individual managers might allocate to regions where they have less expertise. Managers also have to decide whether or not to hedge the client s foreign currency exposure. Most managers hedge their portfolios and measure performance against a currency-hedged benchmark. We believe this to be the most prudent approach given most investors only want exposure to credit risk and are not looking for unintended volatility from foreign currency exposure. 4
GLOBAL HIGH-YIELD PERFORMANCE The unwinding of QE may lead to increased return dispersion among sectors and issuers, offering an opportunity to achieve better risk-adjusted performance Although global high yield offers some advantages for all investors, it is especially pronounced for those domiciled outside the US. Due to the differences in yield, duration and sectors, the performance for US, European and emerging market high yield has varied over the years. US and global high yield are still quite correlated, and thus, at first glance, the benefit for US investors in allocating to global high yield is limited. Figure 3 shows the returns for global, European and emerging market high yield over several market periods. Though global high yield has provided attractive risk-adjusted returns over the past few years, it has lagged US high yield recently. We don t find this too concerning as most of the outsized returns for US high yield in 2016 stemmed from the dramatic rebound in commodity names and the sudden influx of fallen angels whose bond prices quickly rose following their inclusion in the high-yield index. We expect certain periods when global high yield underperforms other high-yield regions, but going forward we would emphasize the value of diversification that global high yield provides. Historical performance numbers have also been distorted by the low-yield environment driven by quantitative easing (QE) within the developed world. Going forward, many market participants believe that the unwinding of QE will lead to increased dispersion of returns among sectors and issuers, and an allocation to a broader opportunity set should deliver better riskadjusted returns in this environment. 5
FIGURE 3. HIGH-YIELD RETURNS 100 HIGH-YIELD MARKET TOTAL RETURNS (%) (USD) 80 60 40 20-0 Global US European Emerging market -20-40 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Source: Bloomberg 20 HIGH-YIELD MARKET TOTAL RETURNS (%) (USD) 15 10 5 0 Global US European Emerging market -5 3 months 1 year 3 years 5 years 10 years Source: Bloomberg 6
CONCLUSION As the non-us high-yield markets continue to evolve, we believe the opportunity set is attractive for investors to allocate to global high yield. Global high yield can provide regional, issuer and industry diversification level protection superior to a stand-alone US, European or emerging markets high-yield mandate. Also, adopting a global portfolio increases the alpha opportunities from having a wider investable universe. 7
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