High-yield bonds have become a global opportunity

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1 By: Yoshie Phillips, CFA, Senior Research Analyst APRIL 2013 High-yield bonds have become a global opportunity Investors seeking income or attractive total return investments often look into high-yield bonds as investment options, and rightfully so. However, they are generally at a loss when deciding between regional and global high-yield products, even though the decision can have real implications. Historically, U.S. companies issuing U.S. dollar denominated belowinvestment-grade bonds have played a dominant role in the high-yield asset class. While this is still so, there is an ongoing capital markets evolution toward global expansion. The European high-yield bond market still accounts for less than a fifth of the global high-yield bond market, but it is rapidly expanding and deepening in its industry and issuer diversification. Emerging markets corporate bonds, increasingly present in global capital markets, have also become a more relevant part of global high yield in recent years. Introduction For investors today, the global high-yield strategy is basically a three-legged stool built on below-investment-grade corporate bonds in U.S., European and emerging markets. Historically, the strategies and performance patterns for the U.S. high-yield and global highyield markets have been similar, but there are increasing signs of differentiation between the two mandates. Furthermore, the selection of active managers may differ, too, depending on whether investors seek to follow a U.S. high-yield or global high-yield strategy. In this paper we set out our strategic perspective on U.S. and global high-yield bond market segments, as well as our observations of how the practices of high-yield bond managers are evolving. Russell believes a global approach to high yield offers the potential for improved issuer and issue diversification and better access to a wider range of alpha sources, and hence it is our generally recommended approach. Russell Investments // High-yield bonds have become a global opportunity

2 Market descriptions High-yield bonds are debt securities rated below investment grade (e.g., BB+ or lower), in that they have a greater risk of default and/or loss on default; therefore, being speculative investments, they are required to offer yields that could compensate investors for taking on such risk. When investors discuss high-yield bonds, they often regard the U.S. high-yield bond market and the global high-yield bond market as being interchangeable. This is understandable, from a historical perspective. The overall performance track records of U.S. companies issuing below-investment-grade U.S. dollar denominated bonds and non-u.s. companies issuing below-investment-grade bonds have been similar, as is evident in a comparison of two of the most widely accepted benchmarks: the U.S. High Yield Master II and the Global High Yield. Furthermore, correlations between the U.S. and the global high-yield bond markets have been extremely high. However, recent evolution in the global high-yield market warrants a closer consideration of differences between the two strategies. GENERAL CHARACTERISTICS The general characteristics of the U.S. and the global high-yield indexes are not too dissimilar, in terms of overall average yield, duration and credit quality (see Figure 1). This is logical, since approximately two thirds of the global high-yield index consists of U.S. dollar denominated bonds. In other words, there is a significant overlap between the U.S. and the global high-yield bond markets. At the same time, the global high-yield market has recently seen an uptick in issuance from a more diverse set of issuers, and many market participants expect this trend to persist (see Figure 2). Figure 1: General characteristics of U.S. and global high-yield indexes U.S. Global Number of issues 2,112 3,098 Market value (billion $) 1,164 1,721 Average quality B1/B2 BB3/B1 Effective duration (years) Yield to worst (%) Option-adjusted spread (OAS) Average price (billion $) Average coupon (par weighted, %) Average maturity (years) Data: as of 12/31/2012 Source: U.S. High-Yield Master II and Global High-Yield GLOBAL HIGH YIELD BECOMING MORE GLOBAL As illustrated in Figure 2, the high-yield investing opportunity set has seen extraordinary growth since its inception in the last 1970s, not only in the U.S. but also globally. The surging market value of the Global High-Yield to $1.7 trillion in market capitalization reflects a demand for global high-yields and indicates a growing acceptance of the asset class. The U.S. high-yield market accounts for approximately $1.1 trillion in market capitalization today, which is more than three times its size in the late 1990s. While the U.S. high-yield market has grown meaningfully, the European high-yield bond market has been expanding even more rapidly and at an unprecedented rate following the recent financial crisis. For instance, the European market more than doubled in size in the wake of the global financial crisis, partly because many borrowing companies have Russell Investments // High-yield bonds have become a global opportunity / p 2

3 Billions ($) rotated from the leveraged loan market and into the high-yield bond market to refinance and meet their capital needs. Banks in Europe have been shrinking their balance sheets, reducing their loan commitments. This disintermediation of banks has also forced many European companies to turn to the high-yield bond market to meet their financial obligations. In addition, European companies issuing U.S. dollar denominated bonds are also a fastgrowing segment. While U.S.-domiciled companies issuing high-yield bonds account for the lion s share of the global high-yield market, increasing numbers of European companies are accessing the dollar-denominated market for their capital needs as a response to ongoing political and economic turmoil in Europe. As a result, high-yield Yankee issuance is at an all-time high, and market observers expect the trend to persist. Most recently, major high-yield index providers have materially changed their inclusion rules so as to represent emerging markets, some of the fastest-growing economies in the world. For instance, when the Global High-Yield changed its rules to include emerging markets corporate bonds at the beginning of 2012, the sector accounted for over 10% of the index (see Figure 2). Emerging markets corporate bonds have become a meaningful global capital markets sector, due to their historically attractive risk-adjusted return profiles and portfolio-diversification benefits, and to the growing size of the opportunity set. In terms of currency, Russell recommends using a currency-hedged benchmark in order to protect against unintended foreign exchange volatility. Figure 2: Market value and regional breakdown for Global High-Yield 1,800 1,500 1, US European EM Others Source: Bank of America Merrill Lynch Note: The Global High-Yield has included high-yield emerging markets corporate bonds since December 31, Russell Investments // High-yield bonds have become a global opportunity / p 3

4 Up-close on the market evolution The global high-yield market keeps evolving, presenting market opportunities in its dynamically changing landscape. Until the 1980s, high-yield bonds simply consisted of socalled fallen angels investment-grade companies that had been downgraded to below investment grade. In the 1980s, the high-yield market entered its next stage of development by including new bonds issued by companies that had borne the below-investment-grade rating from the outset, largely to finance mergers and acquisitions or leveraged buyouts. Today, many of the proceeds of high-yield bond sales are used for general corporate purposes. In the decades since, the composition of the high-yield bond market also has evolved, varying greatly from year to year. Generally speaking, high-yield bonds are senior secured bonds, senior unsecured bonds and subordinated bonds. Mainly because many European borrowers seeking funding sources recently shifted from the leveraged loan market into the high-yield bond market, issuance of senior secured bonds has increased in Europe. Senior secured bonds offer seniority in their asset claims in the event of an issuer s default, which can be attractive to investors. EVOLUTION OF EUROPEAN HIGH-YIELD MARKETS SEGMENTATION Another noteworthy change is in the profile of the European high-yield bond market issuer. The market was not very diverse in its early stages; issuers were mostly concentrated in the telecommunications, media and technology (TMT) sectors. For instance, in 2001 the TMT sectors accounted for more than a third of the European high-yield market. Fast-forward to the credit crisis, and a wave of downgrades of financial issuers to non-investment-grade ratings materially changed the composition of the European high-yield market (see Figure 3). Today, the financial sector represents approximately a quarter of the overall European high-yield bond market. What s more is that the European financial sector has been the market s most volatile in recent years. These shifts in market composition are also evident in the relationship between European core and peripheral countries. There are some key distinctions that set the European high-yield market apart from its U.S. counterpart. Generally speaking, the European high-yield market has relatively higher credit ratings and a shorter average maturity at the aggregate level. The smaller market size and lower liquidity associated with the European high-yield bond market tend to contribute to the spread being more volatile than that of the U.S. high-yield market. More recently, the increase in exposure to financials has been a key driver of higher volatility, as that sector has been notably more sensitive to market fluctuations post financial crisis. Russell Investments // High-yield bonds have become a global opportunity / p 4

5 Weight (%) Figure 3: Historical European high-yield market sector allocation Industrials Financial Utility Source: European High-Yield Different behaviors in market segments One of the arguments supporting a global high-yield strategy over a U.S.-only high-yield strategy is the fact that global economies move at different paces, depending on region, which creates opportunities for active investors to exploit by selecting one favorable region or country over another as they seek to add value. It s true that high-yield bond markets, regardless of region, have relatively higher correlations to one other compared to correlations among investment-grade bond markets. Furthermore, the long-run historical performances of the U.S. high-yield market and the global high-yield market have been very similar. As of December 31, 2012, the five-year annualized performance for the BofA Merrill Lynch U.S. High Yield was 10.1%, compared to 10.7% return for the BofA Merrill Lynch Global High-Yield. However, as evidenced in Figure 4, the performance varied over time, depending on region. The year 2012 is a great example of that variation: the European high-yield market produced a 28.6% return, compared to the U.S. high-yield bond market s 15.6%. Underweighting European high-yield bonds negatively impacted the performance of many global high-yield bond managers in Global high-yield bond investors can be selective; they can concentrate on a few sectors that they believe can withstand volatility and economic weakness. For example, investors can add European high-yield names to their portfolios in order to take some advantage of the regional effect without necessarily being forced into a large position in the highly volatile financials sector (though that would have been positive for performance in 2012). Russell Investments // High-yield bonds have become a global opportunity / p 5

6 Excess return against Global HY (%) Figure 4: Decomposing excess returns for regional high-yield and global high yield markets Source: Bank of America Merrill Lynch Data: Currency hedged to USD U.S. European EM History showing seemingly same performance results between U.S. and global high-yield bond markets To illustrate the historical characteristics of the U.S. and global high-yield bond markets, Figure 5 shows risk/return profiles of the two high-yield markets relative to those of other asset-class markets. As mentioned earlier, over the last decade, the risk/return profile of the global high-yield bond market has been very similar to that of the U.S. high-yield bond market. However, decomposing the global high-yield market such as into European and emerging markets high-yield bonds highlights how U.S. high yield has produced results that differ somewhat from results in European and emerging markets. This exercise also emphasizes the potential for future performance divergence between U.S. and global highyield bond markets if the non-u.s. segment of the global market continues to expand. As a side note: high-yield bonds generated returns exceeding those of other fixed income assets included in the analysis shown below and produced more favorable results than even most equities. Returns for high-yield bonds are generated by two components: coupon income and price change. Coupon income has been the major return driver for the highyield asset class. It is important to note that over time, the coupon component has served to cushion the price volatility of the asset class. This is a key reason why high-yield bonds have generated strong risk-adjusted returns over the long period. Russell Investments // High-yield bonds have become a global opportunity / p 6

7 Return (%) Figure 5: Risk/return profile of high-yield bond markets and other asset classes Return and volatility Barclays U.S. Aggregate Bond JP Morgan Emerging Markets Bond Global Barclays Investment Grade Corporate U.S. High Yield Master II Barclays U.S. Global High Yield Government/Credit BofA ML Global High Yield Constrained - Emerging BofA ML Global High Yield Constrained - European Russell Developed ex-u.s. 0 Citi World Government Bond Data: annualized 14-year data, January 1999 to December 2012 es are unmanaged and cannot be invested in directly. Past performance is not indicative of future results. Source: Russell database. From a long-term perspective, correlations between U.S. and global high-yield bond markets have been remarkably high (see Figure 6). This is part of the reason why many investors treat the U.S. and global high-yield bond markets as being interchangeable. However, correlations of U.S. high yields to European or emerging markets are marginally lower. Given the risk/return profile shown above, we believe greater expansion of the non- U.S. segment of the global high-yield bond market will likely improve the diversification benefit of global high-yield bonds. Russell Standard deviation (%) Russell Investments // High-yield bonds have become a global opportunity / p 7

8 Figure 6: Correlation of U.S. and global high-yield bonds compared to other asset classes Global High Yield U.S. High Yield Master II European High Yield Constrained Emerging Markets Corporate Plus Barclays Investment Grade Corporate BofA Merrill Lynch Global High Yield BofA Merrill Lynch U.S. High Yield Master II BofA Merrill Lynch European High Yield Constrained BofA Merrill Lynch Emerging Markets Corporate Plus Barclays Investment Grade Corporate Barclays JP Morgan U.S. Emerging Government Markets /Credit Bond Global Citi World Government Bond Russell 3000 Russell Developed ex-u.s. Russell Emerging Markets Barclays U.S. Government/Credit JP Morgan Emerging Markets Bond Global Citi World Government Bond Russell Russell Developed ex-u.s. Russell Emerging Markets Source: Russell, Bank of America Merrill Lynch, Barclays, JP Morgan, Citi, Russell Data: Annualized 14-year data from January 1999 to December 2012 es are unmanaged and cannot be invested in directly. Past performance is not indicative of future results. Active management in the global and U.S. high-yield bond markets As the global high-yield market continues to evolve, it presents investment opportunities in its ever-changing landscape. As shown earlier, the performance of high-yield bond markets across the globe differs through time. The opportunity to find better relative value within sectors across different geographies globally can play a very important role in the management of a global high-yield bond strategy. The ability to achieve a diversified asset allocation is a clear differentiator for a global high-yield bond mandate over a U.S. high-yield bond strategy. Active high-yield bond managers have their own unique strengths. Russell has observed that a fair number of traditional U.S. high-yield bond managers continue to operate only within the U.S. market, as they believe their expertise is in analyzing domestic companies. We respect those bond managers who have stayed close to their core strengths. For many years, there have been noticeably more actively managed U.S. high-yield bond product offerings than global high-yield bond strategies in the marketplace. In other words, the number of active managers offering U.S. high-yield bond products is much greater than the number of active managers offering global high-yield bond products. This is understandable, considering the evolution in global markets. Furthermore, we have observed that the majority of global high-yield bond product offerings tend to come from large asset-management firms that have market presence across the globe, but more limited capacity to add value at the securities level. Hence, investors Russell Investments // High-yield bonds have become a global opportunity / p 8

9 choosing between U.S. high-yield and global high-yield mandates have a different pool of bond managers to select from. That said, in recent years, Russell has also observed that an increasing number of assetmanagement firms, including boutique shops, are ramping up their global presence and starting to offer global high-yield bond strategies. While we acknowledge that segregating U.S., European and emerging markets high-yield assets may give up potential alpha propositions from sector rotations across regions, we have observed that many global high-yield bond managers strategically underweight their holdings in emerging markets corporate bonds. In other words, many global high-yield bond managers have opted not to change their investment styles to incorporate the BofA Merrill Lynch Global High-Yield inclusion change that occurred in January The rapidly changing composition of the global high-yield bond market presents several challenges for active investors, particularly in emerging markets corporate bonds. First of all, relative-value comparisons are more difficult. Therefore, building forecasts on the basis of historical relationships is often not as effective. What s more, active managers qualitative investment experience in emerging markets corporate bonds carries much heavier weight even as, given the relative newness of the emerging markets corporate bond sector, experience in emerging markets corporate debt is a relatively scarce commodity. Thus we note that global high-yield managers strategic underweighting of emerging markets corporate bonds might support a dedicated emerging markets corporate mandate in an overall global high-yield bond strategy. Conclusion While the historical data suggests close proximity between the U.S. high-yield and global high-yield bond markets, there is a clear evolution in the non-u.s. segment of the global high-yield bond market. The U.S. high-yield market as a whole continues to grow, but the European and emerging markets corporate bond markets have shown a much greater rate of growth. If this trend persists, the characteristics of the U.S. and the global high-yield markets could diverge further. The shift in characteristics of U.S., European and emerging markets high yield has contributed to expansion of the opportunity set for active managers with the flexibility to invest globally. In this global expansion, investors should give close attention to their selection criteria when choosing between a U.S. high-yield and a global high-yield bond strategy. As discussed above, Russell has observed that a fair number of traditional U.S. high-yield bond managers continue to operate only within the U.S. bond market. We ve also observed that many of the money managers who do offer global high-yield bond strategies tend to underweight the European or emerging markets segments of the global high-yield bond market relative to global indexes weights. A global high-yield bond strategy can seek advantage in an attractive total-return opportunity that provides diversification potential via the geographic and issuer range available in U.S., European and emerging markets high-yield corporate bonds. Ultimately, Russell generally recommends the global approach; we prefer to invest where we believe the market is going, rather than where it has been. Russell Investments // High-yield bonds have become a global opportunity / p 9

10 For more information: Call Russell at or visit Important information Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. These views are subject to change at any time based upon market or other conditions and are current as of the date at the beginning of the document. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Diversification does not assure a profit and does not protect against loss in declining markets. Bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield ("junk") bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages. The trademarks, service marks and copyrights related to the Russell indexes and other materials as noted are the property of their respective owners. Source:, used with permission. is licensing the Indices "as is", makes no warranties regarding same, does not guarantee the quality, accuracy, and/or completeness of the Indices or any data included therein or derived there from, and assumes no liability in connection with their use. Source: Citigroup, 2013 Citigroup LLC. All rights reserved. Source: Barclays, Barclays POINT/Global Family of Indices Barclays Capital Inc. Used with permission. Source: JP Morgan, Russell Investments is a trade name and registered trademark of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide and is part of London Stock Exchange Group. The Russell logo is a trademark and service mark of Russell Investments. Copyright Russell Investments All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. First used: April 2013 (Disclosure revision: December 2014) USI Russell Investments // High-yield bonds have become a global opportunity / p 10

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