High yield high enough?

Transcription

1 Client Education Summit 2012 High yield high enough? Global Head and Chief Investment Officer of High Yield Strategies October 10,

2 Agenda Introduction to high yield bonds The high yield market today Client Education Summit

3 Introduction to high yield bonds

4 What are high yield bonds? Corporate bonds are debts issued by industrial, financial and service companies to finance capital investment and operating cash flow High yield bonds are a subset of the corporate bond sector and is comprised of bonds issued by companies whose debt ratings are below Baa/BBB/BBB as rated by Moody s, S&P and Fitch respectively Ratings of long-term corporate debt securities Moody's S&P Fitch Definition Aaa AAA AAA Highest quality Aa AA AA High quality Investment A A A Upper medium grade Grade Baa BBB BBB Medium grade Ba BB BB Speculative B B B Highly speculative HY Focus Caa CCC, CC Vulnerable to default High Yield Ca> C C Default is imminent C D DDD, DD, D Probably in default To attract investors to buy their bonds and to compensate them for the risks associated with investing in organizations of lower credit quality, these issuers must pay a higher interest rate (high yield) Client Education Summit

5 Common types of high yield securities Plain vanilla fixed rate, cash pay securities Out of all high yield bond securities, plain vanilla securities are the most widely used. They pay cash interest payments at a fixed rate. They typically have a term to maturity of 7 to 12 years and have a callable option built in within the first 3 to 5 years to allow the company to pay off expensive debt as their revenues and credit ratings improve. Rule 144A securities Allows companies to temporarily bypass the typical four week review period required by the SEC before bringing the security to market. Companies will sell high yield bonds to an underwriter and the underwriters, in turn, sells these securities in the secondary market under the safe harbor resale provisions provided by Rule 144A. The issuing company is then responsible for registering these securities within a maximum of 90 days. Payment-in-kind securities Issuers can pay the investor by issuing them more debt securities rather than actually paying the cash interest payment. PIK increases the corporations debt and future cash interest obligations. Split-coupon securities Zero coupon bonds which are issued at a discount do not make coupon payments for an initial period. After that period, the security begins to pay coupon payments. Step-ups Very similar to split-coupon securities, pay low coupon payments in the first three to five years and then increase, or step up, payments in the remaining years until maturity. Client Education Summit

6 Distinguishing loans and high yield bonds Floating-rate loans Floating-rate loans (Senior secured) LIBOR (L) + 2.0% - 4.0% Junior secured capital Second-lien loans L % - 5.0% Mezzanine loans L + 3.0% - 6.0% Unsecured capital First loss capital High-yield bonds 6.5%-10.0% Equity Source: Client Education Summit

7 Distinguishing loans and high yield bonds US loans US high yield bonds Senior Senior or subordinated Secured Covenants Floating rate Unsecured Lighter covenants Mostly fixed rate 6-9 year terms 7-10 years terms Lower liquidity Higher liquidity Callability Call protection Source: Client Education Summit

8 Very strong growth of the high yield market 1,200,000 1,000,000 Par value in USD million 800, , , ,000 0 EU HY marktet US HY market Total par value amount of high yield market has reached more than USD 1.30 trillion Share of the US high yield market is above 80% As of May 2011 Source: BoA Merrill Lynch Client Education Summit

9 A broad range of investors own high yield bonds? Holders have changed over the last decade: More ownership by hedge funds rather than buy and hold CDOs has increased trade volume Greater ownership by foreign investors 2000 Hedge Fund 2% 2010 Equity & Income 5% Broker/Dealer 9% Foreign 7% Insurance Companies 21% Hedge Fund 18% Insurance Companies 17% HY Mutual Funds 14% Pension Funds 20% Foreign 16% Pension Funds 17% CBO 22% Broker/Dealer 7% HY Mutual Funds 15% CBO 4% Equity & Income 6% Source: Credit Suisse. Historical data as at end August For illustrative purposes only. Client Education Summit

10 High yield offers a measure of protection from rising interest rates High yield bonds benefit from lower price sensitivity to interest rate movements (lower duration) During the last 25 years, there have been seven periods when Treasury yields increased more than 100 basis points during a 12-month period High-yield bonds outperformed investment-grade bonds during all seven instances. 12 month Total Return Beginning HY Rise in Change in HY High Yield Investment Spreads Treasury Yield Spreads Bonds Grade Bonds S&P 500 September % 0.2% 43.4% February % 4.7% 11.9% October % -4.8% 3.9% January % -2.6% 10.3% March % -0.5% 18.3% June % -2.2% 8.6% December % 16.7% 26.5% Source: JPMorgan, July 2012 Client Education Summit

11 High yield offers a potential measure of protection from higher inflation Five-year correlation with inflation Inflation 1.00 Bank loans 0.49 High yield bonds 0.31 Commodities 0.30 Large - cap equities 0.15 Short - term bonds 0.12 US TIPS 0.10 Intermediate - term bonds Source: Morningstar, as of 7/31/12. Past performance is historical and does not guarantee future results. Asset class representation: large-cap equities, Morningstar Large Blend category; bank loans, Morningstar Bank Loan category; commodities, Morningstar Natural Resources category; US TIPS, Morningstar Inflation Protected Bond category; short-term bonds, Morningstar Short-Term Bond category; intermediate-term bonds, Morningstar Intermediate-Term Bond category. inflation, US Bureau of Labor Statistics, CPI All Urban. This data is for illustrative purposes and does not represent any DWS fund. It is not possible to invest directly in a category. Correlation over other time periods might not be as favorable. Client Education Summit

12 The direction, not the level, of inflation is what matters Floating rate loans: Average annual total return, 12/31/89 12/31/10 Source: Morningstar as of 12/31/10. Past performance is no guarantee of future results. The graph above is for illustrative purposes only. Floating-rate loans are represented by the Morningstar Bank Loan category. Client Education Summit

13 High yield offers a measure of protection in a low growth world While negative GDP growth is the worst environment for high yield, high growth is not necessary Total returns have been supported by 30 years of falling rates particularly in low growth environments (%) Median HY excess return by GDP bucket (%) Median HY total return by GDP bucket <0% 0% to 2% 2% to 4% >4% -6.0 < 0% 0% to 2% 2% to 4% >4% HY BB B CCC HY BB B CCC Source: Bloomberg. As at July 2012 Annualized return data 1985 to Q Past performance is historical and does not guarantee future results. Client Education Summit

14 The high yield market today

15 Market overview The high yield market has above average spread levels, but a historically low yield The sovereign debt crisis has led to a soaring of volatility and to weakening of the global economy This has also started to negatively impact corporate earnings and the outlook of many companies The default rate is currently still very low. However, due to the more difficult refinancing environment and weaker corporate results we expect a pickup during the next 12 to 18 months This increase should be mitigated by the comfortable liquidity most companies currently enjoy Global structural changes make sector allocation more important, e.g. some sectors suffer from sluggish domestic demand of many developed countries whereas some sectors benefit from strong demand in BRIC countries (i.e. commodities, capital goods) Long term valuation of the high yield market look attractive. However, the volatility should remain very high due to the sovereign debt crisis and economic uncertainty Client Education Summit

16 Historical market performance Average: 7.7% MLY European Currency High Yield Constrained Index Historical average EU HY Index Average: 9.7% MLY US HY Master II Index Historical average US HY Index In the long run the high yield market has achieved a strong average return Before 2008 the US high yield market had suffered only relatively modest losses in down years (the max. loss had been ca. 5%) Source: Merrill Lynch. As at the end of April Past performance is not an indication of future performance. Client Education Summit

17 Historically, high yield has been attractive vs. equity Interesting facts High yield bonds have outperformed equities since 1990 with significantly lower volatility Before 2008, the worst year for the US high yield market was 2000 (-5.2%) The US high yield market has never suffered 2 consecutive years with negative returns US high yield bond market versus equities since year rolling return per unit of risk S&P500 US High Yield Master Index /89 12/90 12/91 12/92 12/93 12/94 12/95 12/96 12/97 12/98 12/99 12/00 12/01 12/02 12/03 12/04 12/05 12/06 12/07 12/08 12/09 12/10 12/11 Source: Bloomberg, Merrill Lynch, ; JPMorgan Client Education Summit

18 Enhanced portfolio risk and return potential An allocation to loans may improve portfolio risk and return over the long-term Investment Grade Credit vs. Bank Loans (Jan 1997 till June 2012) 5.20% 5.00% 4.80% 100% LSTA Return 4.60% 4.40% 90% US Corp 1-3 Years - 10% LSTA optimal risk/reward allocation 100% US Corp 1-3 Years 4.20% 4.00% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00% 6.50% 7.00% Risk Source:. Investment grade credit is the Merrill Lynch US Corporate & Government, 1-3 Year Index. Bank Loans is the S&P/LSTA Leveraged Loan Index. Volatility is measured by the annualized standard deviation in monthly returns; return is measured as annualized average total return. For illustrative purposes only. Not indicative of any investment or investment strategy. Results shown are hypothetical. Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or adhere to a particular trading program in spite of trading losses are material pints which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results. Client Education Summit

19 High yield spreads are very wide relative to defaults 20.00% 18.00% 1816 bp 11/30/ % 14.00% 1096 bp 12/31/ bp 09/30/ bp 06/30/ % 10.00% 8.00% Average STW: 5.96% 6.00% 4.00% Average Default Rate: 4.81% 2.00% 0.00% 315 bps 2/28/ bps 5/31/07 Average STW Average Default Rate CS HY Spread to Worst Moody's Trailing 12 month Default Rate As of June 30, 2012 Source: Credit Suisse and Moody s Investor Services. Past performance is not an indication of future results. Client Education Summit

20 Loan prices have returned to within historical range Loans have recovered but remain wide relative to long-term averages 110 Average price of bank loans January 31, 2000 to June 30, Historical average recovery on defaults for loans: 80.3%* 40 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Avg HY Bond Price Avg All Loans Prices Historical Avg Recovery Rate for Loans Source: Standard and Poor s LCD and S&P/LSTA Leveraged Loan Index. Average Bid of Leveraged Loans; Bloomberg (Merrill Lynch High Yield Master II Index). * Moody s Global Corporate Finance: Corporate Default and Recovery Rates, , February Average time period: Past performance is not an indication of future results Client Education Summit

21 We think focus on intrinsic values is still Key Risk of low recovery for very speculative names remains elevated in our view 4000 BB B Basis points CCC/Split CCC Avg BB Avg B Avg CCC bp 629 bp 469 bp 0 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 As of June 30, 2012 Source: Credit Suisse High Yield Index. For illustrative purposes only. Client Education Summit

22 Factors to assess the attractiveness of the high yield market The following 3 factors are the most important long-term factors to assess the fundamental risk/return profile of the market Valuation level implied by the overall market spread (yield difference to government bonds) Default risk (leading indicators are macroeconomic data and the trend of credit fundamentals) Loss-given-default (normally strongly correlates with the default rate and negatively correlates with the valuation of equities) The following factors are indicators for shorter-term market technicals Level of interest rates and yield curve shape Equity volatility Supply/demand situation (fund flows versus new issue level) Source: Client Education Summit

23 Long-term spread and yield development Despite recent spread tightening, spreads remain significantly above the historical average Yields are nonetheless comparatively low. The reason for low yields is that government bond yields remain extraordinarily low Consequently the yield pick-up versus government bond yields is very high, leading to a strong investor demand as investors look for return without taking excessive risks (e.g. equities) Source: JPMorgan. As at September For illustrative purposes only. Client Education Summit

24 Attractive implied risk premium The current spread level of ca. 640 basis points is well above the fair value level using the historical risk premium Implicit default rates imply defaults need to rise well above the historical average next year We do not expect this given the ample liquidity situation of most corporates Example of HY bond valuations Fair value spread estimate assuming a default rate of 3.0% for 2012 Loss Given Default Estimated Default Rate Default Loss Historical Risk Premium Fair Value Spread (100% - 35%) x 3.0% = 195 basis points basis points = 502 basis points 1 Year Implicit Default Current Spread Level Historical Risk Premium Default Loss Loss Given Default Implicit Default Rate 639 basis points Basis points = 332 basis points / (100% - 35%) = 5.1% Source: JPMorgan,. As at May There is no assurance objectives can be achieved. Client Education Summit

25 But default rates are expected to remain relatively low Many market analysts expect default rates to remain below long-term averages through 2013 (our expectations are for higher) Source: JPMorgan. As at September For illustrative purposes only. Client Education Summit

26 Corporate fundamentals are solid Corporate earnings have risen since 2009 The relative debt and interest burden has declined due to repaid debts and lower interest rates Debt burden Interest coverage As of September 2012 Source: JPMorgan Client Education Summit

27 Issuers have pushed out most of their maturities Inability to refinance is a leading cause of defaults Good news: Issuers have pushed out most of their maturities through refinancing over the last few years Lack of near-term maturities supports our view that default rates should remain low High yield bond and institutional loan maturities Change in the high-yield bond maturity schedule since the end of 2008 USD billion High-yield bonds Institutional leveraged loans or later 0 USD billion or later Source: JPMorgan, Markit. As of end of February The charts above represent forecasts, there is no guarantee the forecast figures will materialise. Client Education Summit

28 Risks to the below investment-grade credit markets Economic deterioration Economic environment deterioration could lead to lower issuer earnings and increased defaults Rising commodity prices Further commodity price increases can hurt issuers, especially food and retail firms on the other hand commodity issuers will benefit Heightened risk aversion Growing uncertainty over sovereign debt or other crises could cause flight to quality Client Education Summit

29 Important information Important risk disclosure Investment in bonds faces the risk that the creditworthiness of the issuer may decline, causing the value of its bonds to decline. In addition, an issuer may be unable or unwilling to make timely payments on the interest and principal on the bonds it has issued. Because the issuers of high yield bonds (rated below the fourth highest category) may be in uncertain financial health, the prices of their bonds are generally more vulnerable to bad economic news or even the expectation of bad news, than those of investment grade bonds. In some cases, bonds, particularly junk bonds, may decline in credit quality or go into default. is the brand name for the institutional asset management division of Deutsche Asset Management, the asset management arm of Deutsche Bank AG. In the US this relates to the asset management activities of RREEF America L.L.C.; in Germany: RREEF Investment GmbH, RREEF Management GmbH, and RREEF Spezial Invest GmbH; in Australia: Deutsche Asset Management (Australia) Limited (ABN ) Australian financial services license holder; in Japan: Deutsche Securities Inc. (For DSI, financial advisory (not investment advisory) and distribution services only.); in Hong Kong: Deutsche Bank Aktiengesellschaft, Hong Kong Branch (for Direct Real Estate business), and Deutsche Asset Management Hong Kong (for Real Estate Securities Business), in Singapore, Deutsche Asset Management (Asia) Limited (Company Reg. No N) and in the United Kingdom, Deutsche Alternative Asset Management (UK) Limited; Deutsche Alternative Asset Management (Global) Limited, in addition to other regional entities in the., and Deutsche Asset Management (UK) Limited; in addition to other regional entities in the Deutsche Bank Group. This material was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. It is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for Deutsche Bank AG and its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein. Neither Deutsche Bank AG nor any of its affiliates, gives any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of the, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person. The views expressed in this document constitute Deutsche Bank AG or its affiliates judgment at the time of issue and are subject to change. The value of shares/units and their derived income may fall as well as rise. Past performance or any prediction or forecast is not indicative of future results. This document is only for professional investors. No further distribution is allowed without prior written consent of the issuer. Any forecasts provided herein are based upon our opinion of the market as at this date and are subject to change, dependent on future changes in the market. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance. Investments are subject to risks, including possible loss of principal amount invested. Certain Deutsche Asset Management investment strategies may not be available in every region or country for legal or other reasons, and information about these strategies is not directed to those investors residing or located in any such region or country. I (10/12) Client Education Summit