INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES: Building a Better Portfolio: The Case for High Yield Bonds

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1 14\GBS\22\25062C.docx INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES: Building a Better Portfolio: The Case for High Yield Bonds By Adam Marks, Area Vice President and Jamia Canlas, Senior Analyst By looking at the data in the table below, to which asset class would you think plan sponsors routinely allocate 4-6 of their assets and which has far less representation? Last 10 Years Last 20 Years Asset Class A Asset Class B Asset Class A Asset Class B Annual Return 7.6% % 9.9% Standard Deviation 11.9% 16.6% 9.9% 17. Return/Risk Best Year % Worst Year -26.4% -37.2% -26.4% -37.2% It turns out that Asset Class A is high yield bonds and Asset Class B is equities. 1 Plan sponsors may shy away from high yield bonds because bonds are supposed to be the safe part of a portfolio and these bonds exhibit more volatility than their investment grade counterparts. Since high yield bonds have characteristics of both investment grade bonds (coupon payments) and equities (volatile price swings), perhaps investors shouldn t frame high yield bonds as risky bonds but rather as an asset class in and of itself with its own risk/return characteristics. Given the attractive risk/return characteristics of high yield bonds as well as their low correlation to investment grade bonds and equities, high yield bonds warrant consideration as a strategic asset class in plan sponsor portfolios. Background High yield bonds are defined as bonds that are rated below BBB- or Baa- by Standard & Poor s, Moody s or Fitch. Issuers considered having a greater risk of defaulting on principal or interest payments are rated below investment grade. Because of their greater risk of default, these issuers must pay a higher interest rate on their bonds to attract investors. The interest rate that below investment grade issuers have to pay varies depending on the economic climate. During recessions, when default rates are high, investors demand more yield. On the other hand, during economic expansions when default rates are low, yields will decline. Credit Risk Moody's Standard & Fitch Poors Investment Grade Highest quality Aaa AAA AAA High quality (very strong) Aa AA AA Upper medium grade (strong) A A A Medium grade Baa BBB BBB Below Investment Grade Lower medium grade (somewhat speculative) Ba BB BB Low grade (speculative) B B B Poor quality (may default) Caa CCC CCC Most speculative Ca CC CC In default C D D Default Rate (Blue Bars) 14% 12% 1 8% 6% 4% 2% Source: FactSet, Moodys Below Investment Grade 2 1 Yield (Green Line) 1 As of 12/31/14. Returns represent and B of A Merrill High Yield Master II. 1 AJG.COM ARTHUR J. GALLAGHER & CO.

2 As opposed to equities which receive the bulk of their return through capital appreciation rather than income (dividends), high yield bonds receive most of their return from income (coupon payments) Source: FactSet High Yield Returns Income Return Price Return Total Return Avg Total Return The high coupon payments have the effect of smoothing returns, making high yield bonds less volatile than equities. In addition, bondholders have priority over stockholders in a company s capital structure. Therefore, in bankruptcy bond holders have a greater chance of recovering their investment than equity holders. Despite their reputation as risky securities, high yield bonds have only produced negative returns in 5 of the last 25 calendar years (core bonds have 3 negative years and equities have 6 negative years). As the chart below shows, over the long term the price swings cancel each other out and high yield returns are driven by the coupon payments. Equity-like Returns. Over the last 20 years as of December 31, 2014 equities have returned 9.9% per year while high yield has returned 8.. Over the last seven and ten year periods - fairly long time horizons - their returns have been almost equal. Since high yield bonds are typically issued by highly levered (or less financially stable) companies, they have a higher risk of default than investment grade bonds. Low default rates are observed when the economy is strong or interest rates are low making it easy for companies to refinance their debt. These are conditions under which equities also tend to perform well. In addition, a high yield issuer s financial health has a large impact on the price of both its bonds and equity. Prices will fluctuate based on earnings reports, corporate actions and product development. An examination of correlations confirms high yield s similarity to equities Annualized Returns 1 Year 3 Years 5 Years 7 Years 10 Years 20 Years Since 1/1/1987 BofA Merrill HY II Rolling 3 Year Correlation Jun-89 Jul-90 Aug-91 Sep-9 2 Oct-93 Nov-94 Dec-95 Jan-97 Feb-9 8 Mar-99 Apr-00 May-01 Jun-02 Jul-03 Aug-04 Sep-0 5 Oct-06 Nov-07 Dec-08 Jan-10 Feb-1 1 Mar-12 Apr-13 May Barclays Aggregate 2

3 High yield bonds have been positively and, at times, highly correlated to equities while no systematic correlation exists between high yield bonds and investment grade bonds. Since high yield bonds have no consistent correlation to investment grade fixed income and correlation that averages around 0.7 with equities, an allocation to high yield bonds can provide diversification benefits to a portfolio. Given their high and sometimes volatile returns, high yield bonds should be considered a part of a plan s return seeking assets, along with equities, rather than part of its volatility dampening assets such as investment grade bonds. With Less Risk Although high yield bonds can produce equity-like returns, they produce these returns with considerably less risk. Two different, yet related, ways to look at risk are the distribution of returns and the standard deviation of returns. Since high yield bond returns are heavily dependent on income, over rolling three year periods returns tend to cluster in the 5 range with fairly thin tails. Equities, on the other hand, exhibit a much wider distribution of returns with outliers ranging from below negative to greater than 3. Again, this begs the question: Which asset class appears to be more attractive? Another way to look at risk is the volatility of returns measured by standard deviation. Volatility varies over time, however equity volatility has historically been higher than high yield volatility. In fact, on occasion this difference has been significant. Observations Rolling 3 Year Returns BofA Merrill HY II Rolling 3 Year Volatility y = x Jun-89 Jul-90 Aug-91 Sep-9 2 Oct-93 Nov-94 Dec-95 Jan-97 Feb-9 8 Mar-99 Apr-00 May-01 Jun-02 Jul-03 Aug-04 Sep-0 5 Oct-06 Nov-07 Dec-08 Jan-10 Feb-1 1 Mar-12 Apr-13 May-14 BofA Merrill HY II ML High Yield II Since high yield bonds can provide equity-like returns with less volatility, a dedicated high yield mandate carved out of a plan s equity allocation could make a lot of sense. Using quarterly returns, high yield has a 0.35 beta to U.S. equities. Therefore, carving out a high yield mandate from a plan s equity allocation can reduce the plan s equity beta without sacrificing much return. 3

4 Effect of Rising Interest Rates Given the current low interest rate environment, it is likely that interest rates will rise in the future. While rising interest rates are generally not a favorable condition for fixed income securities, high-yield bonds are considerably less sensitive to interest rates than other fixed income securities. Rising interest rates can be a sign that the economy is strengthening which may cause high yield credit spreads to narrow. Also, to the extent that there is some capital depreciation due to rising interest rates, the high coupon payments often compensate. When the yield on the ten- year treasury spikes up by at least 100 basis points in a 12-month period, investment grade bonds, as measured by the Barclays Aggregate, tend to have low, and sometimes negative returns. In contrast, high yield bonds have delivered positive returns. 12% 1 12 Month Return 8% 6% 4% 2% -2% -4% Sep bp Feb pb, Yahoo Finance Sep bp Dec bp Increase in 10 Year Treasury Yield BofA Merrill HY II Barclays Aggregate May bp June bp Conclusion High yield bonds have historically produced equity-like returns with less volatility. High yield bonds, with their coupon payments and economically sensitive price movements, have both equity and fixed income characteristics and can be thought of as their own asset class. Because of their strong risk adjusted return potential as well as their low correlation to other asset classes, plan sponsors should consider a strategic allocation to high yield bonds to complement their existing investments in equities, investment grade bonds and alternatives. 4

5 About the Practice Adam Marks, Area Vice President, and Jamia Canlas, Senior Analyst, are part of the Institutional Investment & Fiduciary Services practice of Arthur J. Gallagher & Co., Gallagher Fiduciary Advisors, LLC ( Gallagher ), focused on improving the investment program of your benefit plan and other investment pools. Gallagher s Institutional Investment & Fiduciary Services team is a group of established, proven investment professionals who provide objective insights, analysis and oversight on asset allocation, investment managers, and investment risks, along with fiduciary responsibility for investment decisions as an independent fiduciary or outsourced CIO. Adam Marks Area Vice President Institutional Investment & Fiduciary Services Adam_Marks@ajg.com Jamia Canlas Senior Analyst Institutional Investment & Fiduciary Services Jamia_Canlas@ajg.com ADAM MARKS Area Vice President JAMIA CANLAS Senior Analyst 2015 Gallagher Fiduciary Advisors, LLC Investment advisory, named and independent fiduciary services are offered through Gallagher Fiduciary Advisors, LLC, an SEC Registered Investment Adviser. Gallagher Fiduciary Advisors, LLC is a single- member, limited-liability company, with Gallagher Benefit Services, Inc. as its single member. Neither Arthur J. Gallagher & Co., Gallagher Fiduciary Advisors, LLC nor their affiliates provide accounting, legal or tax advice. 5