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High Yield Credit Opportunities Search (II) 高收益债券 (II)

Earlier this month, Bloomberg reported that high yield bond funds hauled in $3.63 billion in investor cash for the week ended September 19 with 40%, or $1.45 billon, of those inflows. The global high yield market, with approximately $1.3 trillion in size, as of third quarter 2012, continued to rally in the third week of October. The Merrill Lynch BB/B index returned 50 bps for the week which brings to 12.5% for the year.

The high yield bonds generally come with higher coupon rates, better turnaround potential (i.e. companies issuing high yield bonds have the potential to improve business conditions and financial standing therefore creating an opportunity for investors to realize gains as bond values increase), the characteristics of good diversifier, and attractive performance profile.

The August 2012 issue of Strategic Focus by Payden & Rygel says that “Prior to 2009, investing in high yield bonds was considered more tactical than strategic, however, more and more institutional investors are making 5-10% strategic allocations to the asset class. The financial flexibility of these non-investment-grade companies now is far superior to pre-2008 thanks to the massive new issuance in the high yield market over the past three years.”

Investment Philosophy, Research Process, Portfolio Optimization

Among the majority of managers in the U.S., high-yield credit 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 best be accomplished by performing outstanding credit analysis.

In addition, the research approach needs to be implemented with discipline, diversification, and objectivity (with the utilization of quantitative tools), for the purposes of: 1) to balance risk and reward through rigorous asset selection and continuous monitoring of portfolio positions; 2) to mitigate event risk and unexpected losses; 3) to capture changes in risk and return efficiently, and eliminate emotional bias.

Starting with a broad high yield universe, which is usually comprised of over 1,000 issuers, a blend of quantitative and fundamental approaches help identify the highest risk and draw a range of forward-looking probability of default estimate. Typically, the main drivers in this space are asset value, volatility, and leverage. By further analyzing fundamental profiles and relative value both with capital structure and across issuers of the securities that remained on the screen, a high yield credit opportunities portfolio can be built with the following considerations::

  • Bottom-up asset selection
  • Top-down industry overlay
  • Market technicals and trading liquidity impact selection

In monitoring to optimize portfolios, a strong sell discipline with sell signals must be implemented and followed; default probabilities and spreads must be closely monitored. The ultimate goal is to provide attractive absolute yield while limiting exposure to riskiest issuers for downside protection.

Other strategies/techniques include successfully identifying improving credits and near-to-medium term rating upgrades, targeting higher yielding assets with attractive risk-adjusted return, and adding loans with attractive relative value to bonds while gaining security and shortening duration.

Final Thoughts:

  1. Modest economic growth in the U.S., in face of more QE
  2. Europe slipping into recession – challenges remain
  3. Investors challenged to find yield after strong performance
  4. Spreads have room to tighten despite absolute yield levels: 1) high yield provides attractive incremental yield relative to investment grade; 2) loan yields and spreads converging with high yield bonds
  5. High yield bonds – default risk low, spreads at historical averages; high yield loans – default risk low, spreads above historical averages
  6. Fundamentals are supportive for credit: 1) margin benefit from low interest rates and cost cutting; 2) companies conservatively remaining high cash balances
  7. Vigilance in individual security selection remains key: 1) leverage improved from 2008 but new issue trending up; 2) upgrade/downgrade ratio fall to relatively normal levels
  8. Technicals remain positive, with minimal near-term maturing debt: 1) near-term maturities largely refinanced in recent years; 2) new issue supply expected to follow demand
  9. Natural demand supplemented by aggregate inflows: 1) significant annual coupon to be reinvested; 2) volatility inflows but yield-seeking investors continue to provide strong technical bid

2 responses to “High Yield Credit Opportunities Search (II) 高收益债券 (II)”

  1. 5. Leveraged loan would be more favorable if this is the case.
    6. HY is now rich vs. equity gauge if u look at dividends yield. If HY yields = risk premium + UST yields, and UST yields have no room to tight, then only hope for HY is risk premium tighten up.

    But thanks for this excellent write-up

  2. 5. Leveraged loan would be more favorable if this is the case.
    6. HY is now rich vs. equity gauge if u look at dividends yield. If HY yields = risk premium + UST yields, and UST yields have no room to tight, then only hope for HY is risk premium tighten up.

    But thanks for this excellent write-up

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