The Case for Investing in Corporate Bonds Rated Below Single A

Transcription

1 The Case for Investing in Corporate Bonds Rated Below Single A

2 Executive Summary Most non-life insurance companies invest in corporate bonds with a focus on securities rated single A and higher, with only a relatively small allocation to BBB-rated corporates. There are several reasons that insurance companies should consider allowing an allocation to BBB-rated corporates and the higher credit quality spectrum of the high-yield market (BB/B rated). Two major reasons are issuer diversifi cation and increased income return potential. Of course, relative to single-a and higher-rated corporate debt, the risks are higher in the BBB-B quality sector. Given that 44% of the A or better Bank of America Merrill Lynch corporate index is made up of from the fi nancial sector, expanding the use of BBB corporates can create a more diversified corporate portfolio. This diversifi cation is further enhanced by instituting an allocation to B- and BB-rated corporates. As compensation for the additional credit risk, investors receive a higher (pre-default) yield and a higher expected total return. Current yield spreads are approximately at their long-term average, which suggests that they are trading at fair relative value. Risks associated with lower credit quality corporates include credit risk, market (i.e., mark-to-market) volatility and liquidity risk. There are several reasons that insurance companies should consider allowing an allocation to BBB-rated corporates and the higher credit quality spectrum of the high-yield market (BB/B rated). The Case for Investing in Corporate Bonds Rated Below Single A 2

3 The strategic case for lower credit quality corporate bonds The two main reasons for considering expanding investment guidelines to include an allocation to BBB- and BB/B-rated corporates are higher expected return and the opportunity to diversify your corporate exposure across and sectors. Expected Returns The market s compensation for taking additional risk is to price the bonds at a greater yield/yield spread to Treasuries. Since the yield calculation assumes the return of principal at par, it is a pre-default measure of value. Figure 1 shows the relationship through time of the additional compensation associated with different levels of credit risk taken. The average predefault pickup in yield, moving from a single-a-rated corporate to the BBB-rated sector, is about 65 basis points, while moving from A- to BB/B-rated corporates is approximately 35 basis points (although an extra 25 basis points result from the extraordinary spreads associated with 28 and 29). The higher yields need to be adjusted by the potential impact of defaults to get a better understanding of the true expected pickup in yield for taking higher credit risk. Figure 2 uses the long-term historical rating transition matrix published by Moody s Rating Services and calculates a deduction from the yields to equate the historical default adjusted yield associated with the different credit qualities. * The incremental spread hit due to defaults should be deducted from the yields. In other words, the long-term advantage of purchasing a diversifi ed allocation of BBB-rated corporate bonds by selling single-a-rated corporates is about 53 basis points (65 minus 12), while the comparable yield advantage moving from A to BB/B is about 2%. The market s compensation for taking additional risk is to price the bonds at a greater yield/yield spread to Treasuries. Figure 1. Historical corporate spreads Option-adjusted spread (bps) /1/1997 1/1/22 1/1/27 1/1/212 A BBB BB/B Source: BOA ML data from Bloomberg Figure 2. Default rates net of recovery Five-year Annualized Recovery Default rate Rating default rate default rate rate net of recovery A.6%.1% 4.%.7% Incremental spread hit due to defaults BBB 1.6%.3% 4.%.19%.12% BB 7.8% 1.6% 4.%.94% B 19.2% 3.8% 4.% 2.3% 1.55% *The analysis captured in Figure 2 assumes that bonds are held all the way to default. In actual corporate mandates, it is often the case that as a corporate issuer begins to experience a credit event, the active manager will sell the holdings prior to default. This may reduce the impact of actual defaults, although it would tend to increase the impact of downgrades that may not ultimately turn into defaults. The Case for Investing in Corporate Bonds Rated Below Single A 3

4 For income-focused investors, an associated advantage of the lower credit quality issues is that the return advantage comes almost exclusively through income as opposed to capital gains. Issuer and Sector Diversification There is both an issuer and a sector diversifi cation advantage to allowing allocations to below-single-arated corporates. As can be seen in Figure 3, there are about corporate rated A or better within the major public indices. While that appears to be suffi cient for adequate diversifi cation, the number of active that are easily available for purchase is much smaller. In addition, an asset manager will not like the creditworthiness or relative value of many of the, further reducing the opportunity set. By expanding to BBBs, the number of increases to approximately 1,, providing an increased opportunity to gain diversifi cation across names in your corporate portfolio. Another key diversifi cation benefi t of allowing BBB- to B-rated corporates is the relatively large increase in the number of nonfi nancial. We can derive from Figure 3 that there are 29 industrial and 43 utility in the high-quality space. This compares to 42 industrial and 62 utility in the BBB space alone. Figure 3. Issuers in the corporate indices Corporate index Number of Industrial Utility Financial Percentage of Number of Percentage of Number of AAA 9 64% % 5 36% AA 33 46% 4 6% 35 49% A % 39 12% 19 35% BBB 42 67% 62 1% 14 23% BB % 24 8% 29 1% B 53 95% 7 1% 21 4% Percentage of Another key diversification benefit of allowing BBB- to B-rated corporates is the relatively large increase in the number of nonfinancial. The Case for Investing in Corporate Bonds Rated Below Single A 4

5 The risks involved Alongside the yield and return benefi ts associated with lower credit quality investments comes a greater level of risk. These risks manifest in several forms, including: Credit risk Historically, 1.6% of BBB-rated (Baa in Moody s terminology) securities go into default over a fi ve-year period, as can be seen in Figure 4. This compares to a default rate of just.6% for A-rated securities. As should be expected, default rates increase further as you move into the high-yield categories of BB- (Ba- in Moody s terminology) and B-rated corporates. Given that the recovery rate in the case of defaults has historically been about 4%, the impact of defaults can quickly eat into the return advantage of the sector if your default experience is worse than the overall market. The higher default risk in lower credit quality corporates is clearly a concern and is one of the key reasons we advocate the use of an active manager with strong credit research. Market Volatility Risk Market volatility risk of a sector is typically measured by the standard deviation of total returns. As shown in Figure 5, Towers Watson s forward-looking standard deviation for BBB corporates is only slightly higher than A- or better-rated corporates. This is in keeping with the historical risks associated with the credit sectors. In turn, BB/B high-yield bonds are expected to have signifi cantly higher volatility than the investmentgrade assets. The higher default risk is one of the key reasons we advocate the use of an active manager with strong credit research. Figure 4. Average five-year letter rating migration rates, From/To: Aaa Aa A Baa Ba B Caa Ca-C WR Default Aaa 53.8% 23.7% 5.1%.4%.3%.%.%.% 16.6%.1% Aa 3.2% 48.7% 21.2% 3.2%.6%.2%.%.% 22.7%.2% A.2% 8.3% 51.7% 14.3% 2.6%.8%.2%.% 21.2%.6% Baa.2% 1.1% 13.1% 46.6% 8.7% 2.7%.5%.1% 25.3% 1.6% Ba.%.2% 2.2% 12.2% 26.5% 1.7% 1.3%.1% 38.8% 7.8% B.%.%.3% 1.8% 6.9% 22.% 4.8%.7% 44.3% 19.2% Caa.%.%.%.7% 2.% 7.3% 8.8% 1.1% 44.3% 35.9% Ca-C.%.%.%.%.2% 2.1% 1.9% 2.6% 43.9% 49.3% Figure 5. Towers Watson expected total return and risk as of March 31, 212 Expected Risk (standard Asset class Sector Duration Return deviation) Cash.3.67%.62% Core fi xed income U.S. Government 4..84% 3.52% Corporate A % 4.34% Corporate BBB % 4.64% BB/B High Yield % 8.46% Equity Large-Cap Equity 8.7% 16.2% Small-Cap Equity 9.4% 21.1% The Case for Investing in Corporate Bonds Rated Below Single A 5

6 Liquidity in the credit markets became a focal issue at the end of 211, when the corporate bond trading volume for the quarter reached its lowest point since the onset of the 28 credit crisis. Another way to measure market risk is to assess the maximum drawdown (or loss) in each of the sectors. Figure 6 depicts the fi ve largest quarterly drawdowns expressed as total return over the past 1 years. Given that the losses would affect a company s GAAP surplus, economic capital and, potentially, income (depending on the accounting treatment of unrealized gains and losses), before investing in lower credit quality sectors, the company should compare the potential loss of an investment to its risk tolerance. We can see that the worst case for A corporates is signifi cantly more severe than the worst case for BBB corporates. This drawdown occurred in the third quarter of 28, and was a result of the default of Lehman Brothers and the ensuing impact on the fi nancial sector. While this was an extreme event, it highlights the importance of sector diversifi cation. Liquidity risk It can be more diffi cult to sell lower-quality bonds quickly and at an effi cient price when they are compared to the liquidity offered by the highest-rated securities. Typically, the smaller the issue or the lower the credit quality, the less liquidity will be available to investors. This is especially the case when markets are trading with higher volatility. Lower liquidity can also mean that the cost of trading high-yield securities will be higher than trading investment-grade securities. Liquidity in the credit markets became a focal issue at the end of 211, when the corporate bond trading volume for the quarter reached its lowest point since the onset of the 28 credit crisis. A survey of 17 fi xed-income investment managers attributed the diminished liquidity primarily to macroeconomic and seasonality factors.* Figure 6. Five largest quarterly drawdowns Trailing 1 years % 5% 1% % 2% % A corporates BBB corporates B/BB corporates Large-cap equity *Lomelino, D., Corporate Bond Liquidity Constrained, but Active Managers Can Still Excel, Towers Watson, 212 The Case for Investing in Corporate Bonds Rated Below Single A 6

7 Another consideration is that the reduction of broker/dealer corporate bond inventories, as seen in Figure 7, has continued to drive a strain on liquidity. Figure 8 illustrates the sharp reduction in inventory since May 211. Increased capital charges introduced by Basel III and fears over the impact of regulatory legislation included in the Volcker Rule were identifi ed as the catalysts for the 211 reduction of corporate inventories. January 21 to $28 billion in March 212.* These fund vehicles offer daily liquidity and provide beta exposure to market indices. It is expected that highyield bonds included in the major indices will observe elevated liquidity and trade at tighter levels in the foreseeable future. However, these ETFs may be more prone to trend-following investors, and if junk bonds fall out of favor with investors, then the cheapening and liquidity changes may become exaggerated. At the same time that dealers have been shedding corporate bond inventory, fi xed-income exchangetraded funds (ETFs) have witnessed rapid growth. High-yield ETFs have increased from $15 billion in Figure 7. Primary dealer inventory of corporate bonds (maturities greater than one year) Dealer corporate holdings ($ billions) $25 Figure 8. Inventories since April 211 $1 $2 $8 $15 $6 $1 $4 $5 $2 $ Jun 4 Jun 5 Jun 6 Jun 7 Jun 8 Jun 9 Jun 1 Jun 11 $ Apr 11 Oct 11 Apr 12 Source: Federal Bank of New York *Investment Company Institute The Case for Investing in Corporate Bonds Rated Below Single A 7

8 Current relative value Increasing the risk level of a portfolio is prudent only if the investor is appropriately compensated. Lowerquality bonds have historically offered stable yields during normal market periods. During periods of high economic stress, they have seen their yields move considerably higher. Since 1997, the yield for BBB bonds has varied between 4% and 1%, with an average of 6.4% over the period. BB/B bonds have fl uctuated between 6% and 18%, and averaged 9.1% over the same period. If we assume that the long-term historical average spread represents fair value, then A, BBB and BB/B securities are trading at close to fair value. Excluding fi nancials provides a clearer picture of historical spreads when using B/BB and BBB as diversifying assets. Figure 9. Historical corporate spreads Option-adjusted spread (bps) Figure 1. Recent spreads /1/1997 1/1/22 1/1/27 1/1/212 1/1/211 7/1/211 1/1/212 A A average BBB BBB average BB/B BB/B average A A average BBB BBB average BB/B BB/B averag Source: BOA ML data from Bloomberg Figure 11. Historical corporate ex. fin. spreads Option-adjusted spread (bps) Figure 12. Recent corporate ex. fin. spreads /1/1997 1/1/22 1/1/27 1/1/212 1/1/211 7/1/211 1/1/212 A A average BBB BBB average BB/B BB/B average A A average BBB BBB average BB/B BB/B averag Source: BOA ML data from Bloomberg The Case for Investing in Corporate Bonds Rated Below Single A 8

9 Intuitively, yield spreads should be related to default rates. Coming out of the 28 credit crisis, sections of the investment community expressed concerns over a maturity wall that would manifest in 213 and significantly inflate defaults. Issuers have been successful in terming out the maturity profile of their debt when opportunities arose, and the wall has been eroded. Although default rates are projected by Moody s to increase modestly over the next year, the magnitude of defaults is in line with previous periods of economic stability. If Moody s projections of relative stability prove to be accurate, based on historical trends, it is reasonable to expect that spreads for lower-quality assets will tighten beyond the historical average. Figure 14 exhibits our capital market assumptions for forward-looking return and risk characteristics. The assumptions are based on annualized returns over a fi ve-year investment horizon. It can be seen that the BB/B and BBB sectors generate the highest expected Sharpe ratios relative to other fi xed-income sectors. Higher ratios demonstrate that these sectors offer higher risk-adjusted returns. Figure 13. Yield spreads are related to default rates Option-adjusted spread (bps) 16% OAS 1 14% 1 12% 1 1% 12 8% 6% 4% 2% % Jan 97 Jan 99 Jan 1 Jan 3 Jan 5 Jan 7 Jan 9 Jan Jan 13 Trailing 12-month default rate BBB OAS BB/B OAS Source: Moody s and BOA ML Figure 14. Expected Sharpe ratios as of March 31, 212 Asset class Sector Duration Return Risk Sharpe ratio* Cash.3.67%.62%. Core fi xed income U.S. Government 4..84% 3.52%.5 Corporate A % 4.34%.36 Corporate BBB % 4.64%.47 BB/B High Yield % 8.46%.48 Equity Large-Cap Equity 8.7% 16.2%.5 Small-Cap Equity 9.4% 21.1%.41 *The return assumption for cash is used as the risk-free return for the calculation of the Sharpe ratio. The Case for Investing in Corporate Bonds Rated Below Single A 9

10 Further information If you would like to discuss any of the areas covered in more detail, please contact your local Towers Watson consultant or: Andrew Canning Andrew Coupe Please note: This document was prepared for general information purposes only and should not be considered a substitute for specifi c professional advice. In particular, its contents are not intended by Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this document should not be relied upon for investment or other fi nancial decisions, and no such decisions should be made on the basis of its contents without seeking specifi c advice. This document is based on information available to Towers Watson at the date of issue, and takes no account of subsequent developments after that date. Appendix Definitions Based on Standard & Poor s BBB bonds are an obligation exhibiting adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its fi nancial commitment on the obligation. BB bonds are an obligation that is less vulnerable to nonpayment than other speculative issues. However, they face major ongoing uncertainties, or exposure to adverse business, fi nancial or economic conditions that could lead to the obligor s inadequate capacity to meet its fi nancial commitment on the obligation. B bonds are an obligation that is more vulnerable to nonpayment than obligations rated BB, but the obligor currently has the capacity to meet its fi nancial commitment on the obligation. Adverse business, fi nancial or economic conditions will likely impair the obligor s capacity or willingness to meet its fi nancial commitment on the obligation. In addition, past performance is not indicative of future results. This document may not be reproduced or distributed to any other party, whether in whole or in part, without Towers Watson s prior written permission, except as may be required by law. In the absence of its express written permission to the contrary, Towers Watson and its affi liates and their respective directors, offi cers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document including any opinions expressed herein. About Towers Watson Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With 14, associates around the world, we offer solutions in the areas of employee benefits, talent management, rewards, and risk and capital management. Copyright 212 Towers Watson. All rights reserved. TW-NA