The buzz about high yield these days may leave you uncertain whether it’s a good place for your clients to be. After posting a stunning 28% return in 2003, the high-yield market began 2004 with many observers cautioning investors about overvaluation and imminent correction. Before you find yourself agreeing with those naysayers, consider the market’s historical pattern to see how this knowledge might affect your portfolio recommendations and decisions.
Since its inception in the 1980s, when high-yield debt became the most popular means of financing hostile takeovers, the sector has enjoyed two enduring periods of strong performance: from 1981 to 1988, when average annual returns were 15.7%; and 1991 to 1999, when average annual returns were 13.2%. These stretches were interrupted by two relatively short periods of negative performance, from 1989-1990 and 2000-2002. In each cycle, high yield has followed a similar pattern. Charted around a circle, the pattern can be viewed as a clock, as shown in the illustration at right.
The upside runs from 11:00 to about 5:00, with the downside going from 5:00 to 11:00. Unlike a true clock, however, the high-yield clock does not move at a constant rate–it often takes five or more years to move from 11:00 to 5:00, while the move from 5:00 to 11:00 typically only lasts for two or three years. In the two major high-yield cycles we have experienced, the turning points have hinged more on trends in new issuance and default rates than they have on the peaks and valleys of the economy.
In the original high-yield cycle of the 1980s, rising investor interest in this new asset class was met with a fast-growing supply of new issues. In addition to financing the emerging hostile takeover trend, high-yield debt also became increasingly attractive to entrepreneurs and capital-intensive industries that used it to raise cash without diluting equity or dealing with a host of restrictive covenants. Cable and gaming companies, both young industries at the time, were among the big issuers.
As time went on, the new issues continued and investors kept buying. Strong returns caused investors’ credit discipline to slip. The appetite for new deals permitted more and riskier issuers to enter the market, and default rates began to climb. In reaction to rising defaults, investors pulled money out of the high-yield market, and bond prices fell dramatically. Over the two-year period from 1989-1990, the market returned a negative 2%.
The bright side of this period of low returns was that it was purgative: Only the strongest credits survived, while weaker companies went bankrupt. Moreover, investors recommitted to their credit discipline. In 1991, high-yield securities returned almost 40%.
For the next five years, from 1992 to 1997, the high-yield market was relatively stable before warning signs started flashing. Telecommunications companies began to dominate new issues as they sought capital to build their extensive networks. Memories of the last downturn faded, and investors’ credit discipline disappeared. The market for new issues grew steadily, and by 1997-1998, annual new issuance represented 40% of the high-yield market’s total capitalization.
As the dot-com bubble burst in 2000, it became obvious that many of the telecommunications companies that issued bonds in the late 1990s were not viable. Defaults skyrocketed, just as they had a decade earlier. For two and a half years, high yield languished as the natural cleansing process took place. By late 2002, the cycle’s clock was again at 11:00, and the market was poised for the rebound we experienced in 2003.
Today the high-yield clock stands at roughly 2:30. Issuance is trending higher in absolute dollar terms, but the pace is slower when viewed as a percentage of current market capitalization. New issues are now about 20% of the high-yield market–up from 10% in the trough of 2001–but still well below the overheated years of 1997 and 1998 when new issues amounted to 40% of the market. Also, default rates could continue in a downward trend for some time. In January 2004, Moody’s forecast that global default rates for high-yield bonds will fall below their historical average of 4.9% for the first time since 1999, reaching 3.4% by the end of 2004.
High-yield spreads to Treasuries have tightened to about 490 basis points, compared to 1,000 basis points in October 2002 when the risk premium and return potential were both much greater. Clearly, the market’s no longer cheap, but neither is it as rich as the worriers claim. Today’s spreads are only marginally tighter than the market’s long-term average. For much of the 1990s, the market traded at tighter spreads than we are witnessing today.
So how long will it take for the clock to reach 5:00? As they say, past performance is no guarantee of future results, but our analysis suggests that careful high-yield investing could generate 6% to 10% total returns for at least the remainder of the year and possibly longer. Supporting this contention, in addition to the relatively moderate level of new issues, is the fact that many of today’s issuers now are familiar companies refinancing older debts. So far, investors’ appetite for deals and risk is relatively controlled.
So what are the warning signs that investors should be looking for? At this point in the cycle, high-yield investors should pay careful attention to the industry composition of the market. If a new, little-understood industry were to enter the market in a big way–as telecommunications did in the 1990′s–investors should heed the warning that the peak is here and take their gains.
Also, investors should be cognizant of the fact that utilities have emerged as a significant industry group in the market, largely because overcapacity and the taint of Enron pushed many of their credit ratings below investment grade. Today, about 10% of the high-yield market consists of utility bonds. While recent refinancings have helped these companies solve some of their financial problems by increasing their liquidity and improving their debt profiles, only time will tell if they can overcome their more fundamental operating issues.
Finally, high-yield investors should watch the shape of the yield curve. It is not necessarily negative for the high-yield market if the Fed begins to raise interest rates. For example, in 1994 the high-yield market beat US Treasuries handily and matched the return of the S&P 500. However, if the yield curve were to invert at some point (as it did in early 2000), we would consider it to be a very negative sign for high yield.
Adjusting Portfolios to the Current Time Zone
In working with your clients, the first step is to be sure that high-yield securities are consistent with their investment objectives and risk profiles. Although technically part of the fixed-income asset class, high-yield securities are offered by companies with low credit ratings, making them inherently riskier and typically more volatile than other fixed income categories. High yield is better viewed as occupying an investing place somewhere between stocks and bonds on the risk spectrum. While yield might be the most attractive feature, investors must remember that yields can be consumed quickly if principal is eroding. Total return is a more appropriate focus for high-yield investors.
For most individuals with the proper risk tolerance for high yield, buying a portfolio of high-yield bonds directly will be inadvisable because of the challenges involved in building a diversified portfolio of adequately researched bonds at attractive prices. As the advisor, you want to help your clients increase exposure to the sector at the 11:00 point in the cycle and manage the risk at 5:00. For both of you then, a professionally managed vehicle may be the best alternative.
Not all high-yield funds are equal, however. Some are willing to take greater risk on fewer issues, which could deliver the best returns in a market rebound but may significantly underperform when the tide turns. Other managers look to protect their investors on the downside by focusing on higher-quality issues. This method can produce solid returns in a down market, but can lag in a market rebound. Still other managers look for a series of solid singles, with the goal of delivering more consistent performance over time.
In the Putnam High Yield Trust, we choose the third path, adhering to a philosophy of broad diversification so that the portfolios are not overly exposed to any one credit. Also, we carefully monitor the overall risk levels in a portfolio–as broadly measured by beta–and carefully research each credit we buy. In the up part of the cycle, we tend to overweight the lower triple-C credits while underweighting the double-Bs. As we see the market moving toward 4:00, our goal is to gradually assume a more defensive posture by shifting the weightings in favor of the stronger credits.
In high-yield investing, it pays to watch the clock.
Stephen Peacher is chief investment officer in the High Yield Group at Putnam Investments in Boston. He can be reached through [email protected].