DR.CHENJIAZI ZHONG

The 9 July 2012 issue of Pension & Investments mentioned that “institutional investors’ overhaul of their fixed-income portfolios amid ever-lower interest rates and quantitative easing has fueled an exodus out of core fixed income into areas of specialization — particularly emerging markets, high yield and private debt.” In a much larger and more diverse market, by moving into credit and specialist strategies, U.S. investors are aiming to take advantage of the credit risk premium, illiquidity premium, and less vulnerable to interest rate shifts, on a relative basis following the global financial crisis.

As of three-year ending Dec 2011, the number of core bond hires doubled, but the value of the hires fell 28% to $29.6 billion; meanwhile, the number of credit searches rose eightfold, with their value leaping to $8.8 billion from just $252 million in the pre-crisis period. Such transition has manifested even truer in the markets where there are better prospects of boosting returns from active management.

The Basics of High-Yield Bonds

The high-yield bonds have existed since the 1970s. Over decades, the market has broadened and grouped into categories:

• Emerging/start-up companies that have not yet achieved efficiency expected at the investment-grade rating
• Former investment-grade companies experiencing hard times that cause their credit to drop from investment grade
• High-debt companies
• Leveraged buyouts (LBOs) that typically uses high-yield bonds to buy a public corporation from its shareholders
• Capital-intensive companies that require financial resources to produce goods

High-yield fixed income is appropriate for investors whose overall asset allocation suggests a higher risk/reward; the most attractive aspect of the asset class is the high interest income. The coupon is typically 200-500 basis points higher than an investment-grade corporate bond, with the same maturity. The maturities of high-yield fixed income usually range from 7 to 10 years. As an access to potentially higher earnings, of course, this asset class is inherently riskier than higher-rated bonds.

In today’s market, high-yield bonds come in many forms, e.g. cash-pay bonds, step-coupon bonds, payment-in-kind bonds, zero-coupon bonds, convertible bonds.

Investment Philosophy

Among the majority of managers in the U.S., high-yield bonds investing is viewed as the conscious bearing of credit risk for profit and acts as a prudent lender rather than a securities trader, and therefore, the most reliable route to success is through the avoidance of defaults, which can only be accomplished by performing outstanding credit analysis.

Research & Screening Process

The initial screening of securities is to assess credit risk. More commonly, a proprietary credit scoring matrix or a value scoring model which covers the key quantitative and qualitative variables that impact credit quality is utilized. Typically, the inputs to be incorporated are 1) industry position i.e., stability, predictability, barriers to entry, competition, pricing power, and regulatory environment; 2) company position, e.g., assets, profitability, cash flow trends, credit statistics, company scale, ownership, management, event risk, etc.; 3) security position, namely, seniority in capital structure, covenant protection, and corporate structure. Beyond that, fundamental credit analysis also involves comprehensive scenario analysis in which rigorous stress tests and range of probabilities over different timeframes are performed.

Portfolio Construction and Risk Management

In constructing portfolios of high-yield bonds, the primary objective is to earn attractive returns provided by the asset class and to minimize the cost of any credit problems. As a result, the factors to be considered and the steps of high-yield bonds investing should include:

• Fundamentally-driven, bottom-up analysis to select securities and identify catalysts and value drivers
• Diversification across industries and economic sectors is essential
• Estimating assets value, enterprise value coverage, and protections provided through corporate structure and covenants to assess downside protection
• Liquidity, both at the single credit and portfolio level, as investing in liquid credits allows an opportunity to right-size positions and capitalize on market volatility more easily
• Comparable and transaction-based models should also be developed to assess relative value and potential upside and downside parameters

Buy/Sell Discipline

Different managers have different styles, with that said, target position size may or may not be seen in a high-yield bond strategy.

Generally, a sell occurs when 1) holdings are early in spotting credit deterioration; 2) a bond’s price has significantly appreciated and its yield has dropped in absolute terms. In addition, like all other holding-related decision, sell is also made when another bond which offers a better risk/reward tradeoff is found.