The Case for Investing in High Yield Bonds.

Transcription

1 The Case for Investing in High Yield Bonds. High-yield bonds represent an effective tool for increasing long-term returns and reducing volatility in the fixed income portion of investors portfolios. In addition, these securities can provide valuable diversification benefits and higher income streams than investment grade bonds. This article presents the case for investing in high-yield bonds, with specific reference to the PH&N High Yield Bond Fund.

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3 High-yield bonds may invoke a negative connotation to some investors, as they are also referred to in the investment community as junk bonds. As well, the high-yield bond market has been plagued by the actions of a few high-profile and corrupt individuals in the past. However, high-yield bonds in fact represent an effective tool for increasing long-term returns and reducing volatility in the fixed income portion of investors portfolios. This article outlines the case for investing in high-yield bonds and provides recommendations as to how investors can best incorporate a high-yield bond component into their portfolio. Generally speaking, the term high yield refers to bonds that are rated BB or lower based on Standard & Poor s rating system. 1 However, our discussion of the high-yield market also includes BBB rated bonds. At PH&N, we have been actively managing a Canadian high-yield product the PH&N High Yield Bond Fund for over six years. Our investment approach uses detailed credit research, an emphasis on cash-flow analysis, diversification across a variety of industry groups, strict concentration limits by issuer and a rigorous sell discipline. One unique aspect of our approach, as compared to most other high-yield products available in Canada, is our willingness to include an abundant amount of BBBrated issues when conditions warrant (i.e., when the yield spread on such issues is attractive). This makes the PH&N High Yield Bond Fund a somewhat more High-yield bonds became widely popular in the 1980s, thanks largely to American financier Michael Milken, who convinced the investment community that high-yield debt was an efficient and perfectly acceptable means of providing financing for mid-sized firms (which had limited access to capital financings at the time). Prior to Milken s interest in high-yield bonds, corporations rarely issued these securities simply because there was little interest and few participants in the market. While Milken reaped enormous profits in the junk bond market (as did his clients and others who saw the potential in high-yield bonds), his unethical practices and greed led to his downfall, as well as that of the market at the time. He was eventually indicted on numerous counts, including stock manipulation and insider trading. Yet, despite his shortcomings, Milken brought high-yield bonds into the mainstream. Today, many reputable corporations issue high-yield bonds, and these investment vehicles represent an important part of many investors portfolios. conservative product than most peer funds that focus strictly on bonds rated BB and lower. The Growth of the Canadian High-yield Bond Market Over the last several years, the corporate bond market as a whole, including the high-yield sector, has grown substantially. This growth has largely been driven by a confluence of factors including (i) declining government borrowing needs; (ii) more stringent bank lending criteria (which has encouraged more companies to tap into the public bond market); and (iii) a relatively favourable interest rate climate. In the case of the high-yield market, increasing investor demand for yield and greater sponsorship by the investment/dealer community has led this segment of the corporate market to experience particularly fast growth. As a result of this rapid growth, the selection of issuers and industries represented in the Canadian high-yield market has improved dramatically since the early 1990s. This increased level of diversity, combined with greater dealer and investor involvement, has led to improved liquidity in the market. Looking forward, the potential for growth in this market is significant, given that over 70% of the companies listed on the TSX are potential BBB/high-yield issuers (a list of selected BBB and high-yield issuers in Canada may be found on page 4). 1 Bonds are rated based on their financial security characteristics. The most commonly used rating service, Standard & Poor s, assigns bonds alphabetical ratings, with AAA being the highest (generally reserved for government issuers that have virtually no risk of default), followed by AA, A, BBB, BB, etc. A rating of CC is the lowest that a bond can receive before falling into default. Bonds rated AAA to BBB are investment grade ; those rated BB and below are high yield. The Case for Investing in High-yield Bonds 1

4 Attractive Return Opportunities Historical experience in both the Canadian and U.S. markets suggests that attractive return opportunities exist in the middle and lower tiers of the credit spectrum (i.e., BBB, BB, and B-rated bonds), particularly if rigorous credit analysis and strong investment discipline are employed. Return and Characteristics (Jan July 2006 U.S. Experience) High yield has provided an attractive return/risk combination S&P 500 Total Return Index U.S. Treasuries (10-Year) Merrill Lynch High Yield Master Index * Monthly returns annualized. Source: Merrill Lynch, PH&N. The table above illustrates the long-term returns/risks of a broad high-yield index and compares them to other asset categories. The data suggests that over a longer period of time, high-yield bonds provide an attractive risk-adjusted return when compared to U.S. Treasury bonds or the broader equity market. Another way to measure risk is to consider the downside potential for each asset class. Based on this criteria, high-yield bonds also appear quite favourable as indicated in the following table: Return and Characteristics Potential downside risk for high-yield bonds is comparable to 10-Year U.S. Treasuries but much lower than for U.S. equities S&P 500 Total Return Index U.S. Treasuries (10 Year) Merrill Lynch High Yield Master Index Source: Merrill Lynch, PH&N. Return (Annualized) (Annualized Standard Deviation)* Return/ Ratio % 13.8% 0.9x 7.0% 7.0% 1.0x 9.0% 6.7% 1.4x Worst Monthly Return since Jan/1988 Month of Occurrance -14.4% August % July % June 2002 Although the data available in the Canadian markets is limited, historical valuations of the middle/lower tiers of the corporate market suggests that the risk/reward 2 This ratio is calculated by dividing the annualized return into the annualized standard deviation. The higher the ratio, the better. profile for this asset category is favourable over time. The following table shows current yield spreads on different rating categories in the Canadian corporate market. Based on the historical evidence of losses from credit events, these current yield spreads appear to compensate investors well for the potential risk of default. Canadian High-yield Issuers Current risk premiums (July 2006) vs. Canadian loss experience Rating Category Average Yield Spread in Canadian Market * Source: Moody s Investors Services: Average Annual Loss After Recovery Canadian Experience* A bp 0 bp BBB bp 50 bp BB bp 60 bp B bp 200 bp As the above table illustrates, an average BBB-rated bond currently provides investors with a yield advantage of basis points ( %) over a Government of Canada bond with a similar term to maturity. This yield advantage is partially offset by the cost of default, which, on average, detracted 50 basis points (0.50%) of performance from BBB-rated issues from Therefore, the average net benefit to investors who are willing to assume greater credit risk by investing in BBBrated bonds, as compared to Government of Canada bonds, is currently in the range of basis points per annum [( ) 0.50], based on the historical experience of loss. The net advantage of investing in BB and B-rated bonds is even greater. However, investors and fund managers must carefully weigh the risk/reward trade-off as they move down the rating spectrum. For while the yield advantage of investing in lower-rated issues can be very compelling, the risk also becomes much greater. As well, the prices of high-yield bonds that have low credit ratings tend to fluctuate more than the prices of higher-grade bonds. In managing the PH&N High Yield Bond Fund, our fixed income team weighs carefully the quality of each bond compared to its yield advantage and focuses on providing the best risk-adjusted returns. As a result, the Fund typically has a small weighting in bonds rated B or lower, with the bulk of its holdings in the BBB and BB-rated categories. 2 Phillips, Hager & North Investment Management Ltd.

5 Diversification Benefits of High-yield Bonds Although middle and lower tier corporate bonds are influenced by many of the same factors as high-quality fixed income investments or equities (e.g., interest rates, inflation, corporate profit outlook, etc.), this segment of the market does provide meaningful diversification benefits to a traditional investment portfolio. The following table shows the benefits of adding high-yield bonds to a traditional investment grade fixed income portfolio, as illustrated by using PH&N s Bond Fund and High Yield Bond Fund. The Benefits of Diversification Adding high-yield bonds can improve returns while reducing risk for a fixed income portfolio Period from Aug 2000 to July 2006 Source: PH&N. Return (Annualized) A similar result can be shown over a longer period of time by using U.S. data, as illustrated below: The Benefits of Diversification Adding high-yield bonds can improve returns while reducing risk for a fixed income portfolio (Annualized Standard Deviation) Return/ Ratio PH&N Bond Fund 7.5% 3.5% 2.1x Combined Portfolio (2/3 PH&N Bond Fund and 1/3 PH&N High Yield Bond Fund, rebalanced monthly) U.S. Market Statistics Jan 1988 to July 2006 Merrill Lynch Master Bond Index 8.4% 3.4% 2.5x Return (Annualized) (Annualized Standard Deviation) Return/ Ratio 7.6% 4.4% 1.7x Empirical evidence shows that by allocating part of the bond portion of one s portfolio to high-yield bonds (in the form of the PH&N High Yield Bond Fund, for example), investors can increase their portfolio s longterm returns while reducing its overall risk. 3 Conclusion The inclusion of high-yield bonds in a fixed income or balanced portfolio can be an appropriate and rewarding strategy. However, as the high-yield market is dynamic and complex (changing fundamentals for middle and lower tier credits can have a notable impact on returns), investors are well advised to seek professional management when investing in this market. At Phillips, Hager & North, our team of fixed income professionals which is one of the largest in Canada has extensive experience in the credit analysis process. In addition, we have made significant investments in analytical systems, risk management tools and third-party research to help strengthen our investment process. The results of our efforts are reflected in the PH&N High Yield Bond Fund s superior risk-adjusted returns, which we expect will continue to reward investors into the future. Investors interested in learning more about incorporating the PH&N High Yield Bond Fund into their portfolio are encouraged to contact our Investment Funds Centre at In our example, we allocate 1/3 of a bond portfolio to high-yield bonds. This strategy may not be appropriate for everybody, and investors should consult with their financial advisor to determine a suitable high-yield bond allocation for their portfolio. Combined Portfolio (2/3 Master Bond Index and 1/3 High Yield Bond Index, rebalanced monthly) 8.1% 4.1% 2.0x Source: Merrill Lynch, PH&N. As the data above suggests, a combination of investment grade and high-yield bonds can help an investor achieve higher annual returns with less risk. High-yield bonds have different return characteristics than other asset categories and can therefore provide attractive diversification benefits to a fixed income or balanced portfolio. The Case for Investing in High-yield Bonds 3

6 Sample of Canadian High-yield Issuer Base 4 Selected BBB Issuers Agrium Boardwalk REIT Canadian Natural Resources Canadian Oil Sands Canadian Tire Inco Ltd. Finning Husky Energy Precision Drilling Manitoba Telecom Nexen Shoppers Drug Mart Sobeys RioCan REIT Talisman Teck Corp. Summit REIT Transalta Corp. West Fraser Timber Telus Inc. YPG Holdings Inc. Selected BB Issuers Rogers Cable Bombardier Capital Bombardier Inc. Bowater Shaw Communications Sears Canada Rogers Communications Nova Chemicals Norampac Inc. Selected B Issuers Ainsworth Lumber Bombardier Recreational CanWest Global Media Intrawest Corp. Jean Coutu Lindsey Morden Millar Western Forest Corp. Nortel Networks Quebecor Media 4 As of July Phillips, Hager & North Investment Management Ltd.

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8 Rates of return, unit prices and distributions are for Series A units of the Phillips, Hager & North investment funds. Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in unit value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. VANCOUVER Waterfront Centre 20th Floor 200 Burrard Street Vancouver, British Columbia Canada V6C 3N5 VICTORIA St. Andrew s Square I Suite Yates Street Victoria, British Columbia Canada V8W 1L6 Phillips, Hager & North ( PH&N ) is a registered trade name for Phillips, Hager & North Investment Management Ltd. ( PH&NIM ) and its wholly-owned subsidiary Phillips, Hager & North Investment Funds Ltd. ( PH&NIF ). PH&NIM is the fund manager for all PH&N investment funds as well as for the BonaVista Canadian Equity Value Fund and the BonaVista Global Balanced Fund. PH&NIM is also the principal portfolio adviser for all PH&N funds. PH&NIF is the principal distributor of the units of the PH&N funds and the two BonaVista funds. BonaVista Asset Management Ltd. ( BonaVista ), a wholly-owned subsidiary of PH&NIM, is the principal portfolio adviser for the two BonaVista investment funds. Sky Investment Counsel Inc. ( Sky ) is the sub-adviser with respect to non-north American equity assets at PH&N, including those held in all PH&N investment funds and in the BonaVista Global Balanced Fund. PH&N holds a substantial, non-controlling interest in Sky. Publication date: August 18, 2006 CALGARY Bankers Hall West Tower Suite rd Street S.W. Calgary, Alberta Canada T2P 5C5 TOR ONTO Suite Adelaide Street East Box 207 Toronto, Ontario Canada M5C 2V9 MONTREAL Tour McGill College Suite McGill College Avenue Montreal, Quebec Canada H3A 3M8 INVESTMENT FUNDS ADVICE & INFORMATION Telephone: Facsimile: Website: info@phn.com