In Search of Yield. Actively Managed High Yield Bond Funds May Offer Long-Term Value

Transcription

1 In Search of Yield Actively Managed High Yield Bond Funds May Offer Long-Term Value

2 In Search of Yield The Case for Actively Managed High Yield Bond Funds CONTENTS 2 Losing Ground to Inflation: The Impact of Lower Yields 3 In Search of Higher Yield 4 High Yield Bonds May Offer a Valuable Measure of Non-Correlation 5 A Blend Of High Yield and High Quality Bonds May Optimize a Portfolio s Risk/Return Profile 6 Mutual Funds and ETFs: Two Ways to Invest in High Yield Bonds 8 Conclusion EXECUTIVE SUMMARY The income dilemma In the quest for sustainable income sources that can keep pace with inflation, investors have been confronted with a dilemma in the low yield environment of recent years, traditional high quality bonds have not generated enough income to meet the near term requirements of retirement-minded individuals or the funding liabilities of institutions. High yield bonds have their attractions For investors who can sustain some increased portfolio volatility, high yield bonds may offer three distinct benefits. First, they may pay a higher coupon than Treasuries and high grade corporate bonds. Second, they may also have a lower sensitivity to price declines than their higher quality counterparts during periods of rising interest rates. Third, since high yield bonds tend to track equity market behavior, they may offer a valuable measure of noncorrelation to a portfolio. When combined with other income asset classes in a diversified portfolio, high yield bonds may temper principal fluctuation and potentially enhance returns over the long term. Mutual funds versus exchange traded funds (ETFs) The two most popular vehicles for investing in high yield bonds are mutual funds and ETFs. While both investment types share some traits, there are differences in their technical features, portfolio characteristics and costs that impact the bottom line. A close comparison between the two is important before an informed investment decision can be made. The assertions in this white paper are based on RidgeWorth s opinion. Bonds offer a relatively stable level of income, although bond prices will fluctuate providing the potential for principal gain or loss. Intermediate-term, higher quality bonds generally offer less risk than longer term bonds and a lower rate of return. Generally, fixed income securities will decrease in value if interest rates rise and vice versa. Floating rate loans are typically senior and secured, in contrast to other below-investment grade securities. However, there is no guarantee that the value of the collateral will not decline, causing a loan to be substantially unsecured. Loans generally are subject to restrictions on resale. Stocks are more volatile and carry more risk and return potential than other forms of investments. IN SEARCH OF YIELD 2

3 LOSING GROUND TO INFLATION: THE IMPACT OF LOWER YIELDS Following the market downturn of , the Federal Reserve and overseas central bankers collaborated in an effort to maintain lower interest rates to stimulate investments and revitalize the economy. Against this low interest rate environment, traditional high-quality securities, represented in Exhibit 1 by the U.S. 10-year Treasury Bond, occasionally delivered yields that were equal to or lower than the rate of inflation as measured by the Consumer Price Index. Exhibit 1: Even at Today s Relatively Low Rate of Inflation, Low Yields from High-Quality Income Debt Instruments May Result in a Loss of Purchasing Power to Income-Oriented Investors ( ) 20 Annualized Total Return (%) n CPI Inflation n 10 Year U.S. Treasury Sources: Bureau of Labor & Statistics and U.S. Department of Treasury, as of 12/31/13. Real returns are adjusted by rates of inflation; differences are due to rounding. IN SEARCH OF HIGHER YIELD By paying a higher coupon than Treasuries and high grade corporate bonds, high yield bonds may offer a way to capture a more attractive level of income. However, they are more vulnerable to credit risk than higher quality bonds. Many of these securities are rated below investment grade by Standard & Poor s or Moody s (at BB or below) or are not rated at all. Still, as the current low yield environment has intensified, the advantages of at least some exposure to high yield investments may be beneficial to investors who can tolerate a higher level of short term volatility. In general, when interest rates rise, bond prices fall, and vice versa. Accordingly, in a rising rate environment, bondholders may see the value of their holdings decline. Due to their higher yields, however, high yield securities may also have a lower sensitivity to price declines than their higher quality counterparts during periods of rising interest rates. IN SEARCH OF YIELD 3

4 As Exhibit 2 illustrates, yields declined across all major bond categories from 10/01/07-12/31/13. Yet, the high yield sector demonstrated surprising resilience and out performance throughout the period. Exhibit 2: High Yield Bonds Have Surpassed the Yields of Other Popular Fixed Income Choices ( ) Average of SEC Yield n High Yield Bond n Intermediate Government n Intermediate-Term Bond n Muni National Intermediate Bond n World Bond Source: Morningstar, as of 12/31/13. HIGH YIELD BONDS MAY OFFER A VALUABLE MEASURE OF NON-CORRELATION Considered hybrid securities, high yield bonds share the characteristics of both stocks and bonds. As corporate securities, their prices tend to track the behavior of the equity market even though they pay income like other fixed income vehicles. With their low correlation to much of the fixed income market, high yield bonds can add an important degree of diversification to a portfolio. In Exhibit 3, from 12/01/03 12/31/13, high yield bonds, represented by the Credit Suisse High Yield Index, demonstrated a negative correlation to all of the U.S. Treasury indexes. Instead, high yield bonds correlated most closely with large and small capitalization stocks, followed by corporate bonds. While there is no guarantee, low correlation with the fixed income market may offer a potential cushion against price declines during a rising rate environment. IN SEARCH OF YIELD 4

5 Exhibit 3: High Yield Bonds Correlate More Closely to Stock Market ( ) Credit Suisse HY USD Barclays Interm US Treasury TR USD BofAML US Corp Master TR USD Russell 1000 TR USD Russell 2000 TR USD Barclays US Treasury 7-10 Yr TR USA BofAML US Treasury Bill 3 Mon TR USA S&P 500 TR USD Source: Factset, as of 12/31/13. Data from 01/01/04-12/31/13. A BLEND OF HIGH YIELD AND HIGH QUALITY BONDS MAY OPTIMIZE A PORTFOLIO S RISK/RETURN PROFILE When combined with other income asset classes in a diversified portfolio, high yield bonds may temper principal fluctuation and potentially enhance returns over the long term. In Exhibit 4, an allocation of 30% high yield bonds and 70% U.S. Treasuries offered almost half of the volatility of a hypothetical portfolio of U.S. Treasuries, with a slight increase in return. By including a lower quality, higher risk component with a higher quality position, risk is substantially lower than a 100% U.S. Treasury portfolio. Additionally, a blended portfolio of 65% high yield and 35% Treasuries delivered substantially less risk than a pure high yield portfolio, while maintaining a very competitive return. Located in the northwest quadrant of the chart, this blend demonstrated a particularly attractive level of portfolio efficiency. Exhibit 4: High Yield Bonds May Add a Measure of Performance Efficiency to an Income Portfolio ( ) % High Yield Annualized Total Return (%) % High Yield / 35% Treasury % High Yield / 70% Treasury 100% Barclays 7-10 Year Treasury Annualized Standard Deviation Source: Morningstar and FUSE, as of 12/31/13. Data from 01/01/94-12/31/13. IN SEARCH OF YIELD 5

6 MUTUAL FUNDS AND ETFS: TWO WAYS TO INVEST IN HIGH YIELD BONDS Most investors attracted to the high yield market will prefer one of two ways to invest: 1. High Yield Mutual Funds, which are managed by active, professional managers who research the high yield market to make decisions about whether to buy, hold or sell securities according to a fund s stated objectives. Most mutual funds are actively managed and seek to outperform market indexes. 2. Exchange Traded Funds (ETFs), which invest in passive portfolios of high yield securities that track the performance of major indexes such as the Barclays U.S. Corporate High Yield Bond Index. Most ETFs do not attempt to outperform during rising markets or take defensive positions in declining markets, although performance may diverge somewhat from an ETF s underlying index. The major difference between these two vehicles is the style of management that guides them. Active managers rely on research and judgement to make investment decisions for their portfolios. Passively managed investments mirror indexes and do not utilize active management of the investments. Other key aspects that distinguish actively managed mutual funds from ETFs are as follows: } Tracking Errors and Their Consequences Tracking error measures the difference between the return of a portfolio and its benchmark index. Strategies with a high tracking error tend to be more volatile relative to an index and may increase downside risk. In contrast, a strategy that features a low tracking error can potentially help investors minimize volatility. Actively managed mutual funds typically deviate from an index in an effort to generate excess returns. In contrast, ETFs are expected to approximate the returns of a tracking index or basket. With an eye to shifting markets, active, professional managers may evaluate opportunities and make portfolio adjustments to avoid activities that lead to a higher tracking error. A mutual fund that possesses a lower than average tracking error and distinguishes itself via bond selection may add to total return without significantly increasing volatility relative to its benchmark and peer groups. On the other hand, passively managed high yield ETFs are designed specifically to replicate the performance of their tracking index or basket. In this case, illiquidity and transaction costs can have large impacts. ETFs do not have the structure to manage credit or pricing risks or take advantage of pricing inefficiencies. IN SEARCH OF YIELD 6

7 } Liquidity Exchange traded funds permit investors to buy and sell shares of the underlying portfolio throughout every business day just like a stock investment. On the other hand, shares of a mutual fund can be redeemed only once a day at the then current net asset value. } Market Volatility Mutual fund managers can apply their knowledge of the high yield market to make selections where they see opportunity. The fiscal outlook of a company or industry may be just as important as credit considerations in determining a mutual fund s high yield security selections. High yield ETFs have constraints within their investment portfolios that limit their ability to respond when confronted with destabilizing market events or sudden opportunities. While ETF managers maintain a steady state according to the dictates of a particular index, most active managers have the flexibility to move defensively or aggressively according to market events. } Costs In general, ETFs cost significantly less than mutual funds, which charge a fee to pay professional managers to oversee the fund. Typically, ETFs charge investors an expense ratio plus transaction costs, while fees for a mutual fund may include expense ratios as well as a sales load or redemption fee. If a number of high yield ETF managers all needed to buy a particular bond in response to a change in their index, such market-driven trading activities may drive up a bond s price. However, active mutual fund managers, significantly, often assess a bond s valuation relative to its peers before making the decision to buy. } Performance Results The default of a bond can trigger a loss in a portfolio s value. Active managers can monitor default risk in pursuit of capital preservation, while accessing the full universe of high yield bond offerings. On the other hand, high yield ETF tracking indexes are tightly defined, very specific and frequently exclude a large portion of the issues available. A successful high yield strategy for a mutual fund is as much about reducing exposure to potential defaults as it is about pursuing attractive income. Factors such as duration and credit spreads are critical to knowing when to buy, sell or hold a security. For example, a spike in interest rates may persuade a manager to modify the portfolio s credit exposure, while other assets may be deployed to take advantage of a shift to a favored industry. IN SEARCH OF YIELD 7

8 CONCLUSION In the low yield environment of recent years, traditional high-quality bonds have not generated enough income to meet the near-term requirements of retirementminded individuals or the funding liabilities of institutions. Against this interest rate backdrop, traditional high-quality securities occasionally delivered yields that were equal to or lower than the rate of inflation as measured by the Consumer Price Index. While high yield bonds have risks, they may offer advantages to investors who can tolerate a measure of portfolio volatility. While past performance is no guarantee of future results, high yield bonds have paid a higher coupon than Treasuries and high grade corporate bonds over the past five years. High yield bonds may have less sensitivity to price declines than their higher credit quality counterparts during periods of rising interest rates. High yield bonds may offer a valuable measure of non-correlation to a portfolio. When combined with other income asset classes in a diversified portfolio, high yield bonds may help temper principal fluctuation and potentially enhance returns over the long term. High yield bond mutual funds with a low tracking error have the potential to minimize the impact of market-related activities that may affect indexes, indexbased funds and ETFs. While ETFs offer lower fees and can be sold at any time throughout the business day just like a stock, high yield mutual funds hire a professional team of managers and credit analysts to monitor research and make the decision when to buy, sell or hold securities. If fees are not the first consideration and an investor s objective is to pursue a higher than average fixed income yield with the potential for reduced risk, a high yield mutual fund investment combined with a high quality bond portfolio may offer an attractive level of risk-adjusted return. To learn more, please visit or call our Sales team at Download other RidgeWorth White Papers at: ridgeworth.com/news-insights/ridgeworth-research IN SEARCH OF YIELD 8

9 About RidgeWorth Investments RidgeWorth serves as a money management holding company with six style-specific institutional investment management boutiques, each with a well-defined, proven approach and all with unwavering commitments to exceptional performance. Through our multiple, style-specific boutiques, we offer a wide range of equity and fixed income investment disciplines. RidgeWorth Investments, an investment adviser registered with the SEC since 1985, is headquartered in Atlanta, Georgia. Investment Risks Bonds offer a relatively stable level of income, although bond prices will fluctuate providing the potential for principal gain or loss. Intermediate-term, higher-quality bonds generally offer less risk than longer-term bonds and a lower rate of return. Generally, a fund s fixed income securities will decrease in value if interest rates rise and vice versa. U.S. Government guarantees apply only to the underlying securities of the fund s portfolio and not the fund s shares. Floating rate loans are typically senior and secured, in contrast to other below- investment grade securities. However, there is no guarantee that the value of the collateral will not decline, causing a loan to be substantially unsecured. Loans generally are subject to restrictions on resale. Certain types of loans may limit the ability of the Fund to enforce its rights and may involve assuming additional credit risks. This information and general market-related projections are based on information available at the time, are subject to change without notice, are for informational purposes only, are not intended as individual or specific advice, may not represent the opinions of the entire firm, and may not be relied upon for individual investing purposes. Information provided is general and educational in nature, provided as general guidance on the subject covered, and is not intended to be authoritative. All information contained herein is believed to be correct, but accuracy cannot be guaranteed. This information may coincide or conflict with activities of the portfolio managers. It is not intended to be, and should not be construed as investment, legal, estate planning, or tax advice. RidgeWorth Investments does not provide legal, estate planning or tax advice. Investors are advised to consult with their investment processional about their specific financial needs and goals before making any investment decisions. Past performance is not indicative of future results. IN SEARCH OF YIELD 9

10 Investment Terms Below-Investment-grade Securities: Fixed income securities that carry a rating of BB or lower by Standard & Poor s or Ba or lower by Moody s. These bonds have greater default risk than investment-grade bonds and typically offer higher yields to compensate for that risk. As such, they often are referred to as high yield bonds. Consumer Price Index is a measure that examines the weighted average of prices of a basket of consumer goods and services. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Coupon Rate: The stated interest rate on a debt security when it is issued. Credit Risk: The risk that the issuer of a debt security will default on its commitment to pay interest and repay principal. Default Risk: The risk companies will be unable to make required payments on their debt obligations. Inflation: The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Interest Rate Risk: The risk that a bond s price will fall when interest rates rise. Liquidity Risk: The risk an investment s lack of marketability will prevent it from being bought or sold quickly enough to prevent or minimize a loss. Standard Deviation: A measure of the dispersion of a set of data from its mean; the more spread apart the data, the higher the deviation. Standard deviation is applied to the annual rate of return of an investment to measure the investment s volatility. 10-Year Treasury Note: A debt obligation issued by the United States government that matures in 10 years; pays interest at a fixed rate once every six months and pays the face value to the holder at maturity. Total Return: When measuring performance, total return is the actual rate of return of an investment or a pool of investments over a given evaluation period. Total return includes interest, capital gains, dividends and distributions realized over a given period of time Yield: The income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment s cost, its current market value or its face value. IN SEARCH OF YIELD 10

11 Index Definitions Barclays Intermediate US Treasury Total Return includes all publicly issued, U.S. Treasury securities that have a remaining maturity of greater than or equal to 1 year and less than 10 years, are rated investment grade, and have $250 million or more of outstanding face value. Barclays US Treasury 7-10 Year Total Return measures the performance of U.S. Treasury securities that have a remaining maturity of at least seven years and less than 10 years. Bank of America Merrill Lynch U.S. Corporate Master Total Return includes publicly-issued, fixed-rate, nonconvertible investment grade dollar-denominated, SEC-registered corporate debt having at least one year to maturity and an outstanding par value of at least $250 million. Bank of America Merrill Lynch US Treasury Bill 3-Month U.S. Treasury Bill Index is an index of short-term U.S. Government securities with a remaining term to final maturity of less than three months. Credit Suisse High Yield Index tracks the performance of domestic noninvestment-grade corporate bonds. Russell 1000 Index measures the performance of approximately 1,000 of the largest companies in the U.S. equity markets. Russell 2000 Index measures the performance of the small cap segment of the U.S. equity universe, including approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. Standard & Poor s 500 Total Return Index is an unmanaged index of 500 selected common large capitalization stocks (most of which are listed on the New York Stock Exchange) that is often used as a measure of the U.S. stock market. Investors cannot invest directly in an index. An investor should consider the fund s investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information about the RidgeWorth Funds can be found in the fund s prospectus. To obtain a prospectus, please call or visit Please read the prospectus carefully before investing Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is not indicative of future results. The performance data quoted represents past performance and current returns may be lower or higher. Total return figures include change in share price, reinvestment of dividends and capital gains. The investment return and principal value will fluctuate so that an investor s shares, when redeemed, may be worth more or less than the original cost. For performance data current to the most recent month end, visit our website at RidgeWorth Investments. RidgeWorth Investments is the trade name for RidgeWorth Capital Management, Inc., an investment adviser registered with the SEC and the adviser to the RidgeWorth Funds. RidgeWorth Funds are distributed by RidgeWorth Distributors LLC, which is not affiliated with the adviser. Collective Strength Individual Insight is a federally registered service mark of RidgeWorth Investments. Not FDIC Insured No Bank Guarantee May Lose Value IN SEARCH OF YIELD 11

12 RFWP-HY-0114