Very low US Treasury rates are a dominant feature of today s financial markets. Their effects are widespread across those markets and throughout the global economy. This paper examines the impact that these low rates are having on US high yield bonds in terms of potential returns, volatility, and correlations with other asset classes. These topics are of interest to us, as managers of both long-only and absolute return high yield bond portfolios. It is also of interest to consultants and institutional investors who seek to allocate funds to the high yield asset class such that they contribute to the overall portfolio s total returns and Sharpe ratios. We reach three important conclusions: While upside becomes limited when the Bank of America Merrill Lynch Master II Index approaches a price of 104, yields, spreads, and returns are likely to remain attractive until Treasury rates rise meaningfully or the economy stumbles. In the low rate environment, the Treasury component of high yield returns is less significant, and the equity component more significant, so high yield bonds are more correlated to equities and negatively correlated to Treasuries. As a result, the efficient frontier between high yield and Treasury bonds has shifted considerably and favorably for fund managers seeking to enhance returns and/or reduce risk in fixed income portfolios. With risk-free rates at historic lows, it is not surprising that investors can enhance returns by incorporating a substantial allocation of well-managed high yield bonds into their overall portfolios. We demonstrate that this strategy reduces volatility, too, especially in the current low rate environment. Economic Backdrop The US economy is in its third year of recovery from the dramatic recession that began with the housing crisis in 2007 and encompassed the collapses of Bear Stearns, Lehman Brothers, GM, and Chrysler, among many. This has been a fits and starts recovery, fueled by fiscal stimulus and generously accommodative Fed policies. Fortunately, consumers continue to spend despite stretched budgets, stubbornly high unemployment, and the mori- bund housing market. Businesses, on the other hand, are reluctant to invest and create jobs because they have little confidence in the expansion and because the ambiguous political and regulatory environment creates unforeseeable risks. Beyond our borders, continuing stress in Europe, slowing growth in China, and heightened tensions in the Middle East are contributing to uncertainty for businesses and choppy markets for investors. 6% 4% 2% -2% -4% -6% Trailing 4 Quarters Real GDP Growth Source: U.S. Bureau of Economic Analysis, Bloomberg After shrinking by 3.7% from July 2008 to December 2009, Real GDP rebounded to 3.1% growth in 2010. That was a healthy rate of expansion for the early part of the recovery, and economists expected some acceleration in 2011. Instead, growth slowed almost to a standstill in the first quarter and then rebounded slowly, such that it amounted to only 1.6% for the full year. For the second year in a row, job creation was anemic and the housing market failed to recover even modestly, despite the very low interest rates. Also, oil prices rose to more than $100 a barrel, and most industrial commodities followed suit. Despite these headwinds, economists are projecting slow growth to continue in 2012, within a range of 2 3%, and mostly in the second half. The energy, technology, media, and consumer sectors are likely to drive much of this expansion. Only a few economists are expecting a downturn during the coming 18 months, but growth is not accelerating and the outlook for employment remains discouraging. Particularly because of high unemployment, US policymakers and central bankers are highly motivated to stimulate the economy. 1
Low Treasury Rates Chairman Bernanke recently reaffirmed the Fed s intention to hold interest rates at low levels until late 2014, hoping to bolster confidence and promote investment in risk assets. The second of its quantitative easing programs has been extended through the end of 2013, and many market participants are anticipating a QE III if the economy slows further. Some economists disagree with this easy money approach. Many fear it will fuel inflation. Others argue that low rates are not an adequate remedy when business confidence is low, likening them to pushing on a string. Certainly, savers and fixed income investors are struggling to maintain current income. Conversely, borrowers benefit. They are able to refinance to lock in low rates, thereby improving creditworthiness and freeing capital for more productive uses. Also, overextended borrowers are more likely to avoid default when capital is available and borrowing rates are low. Equity investors benefit, too. Stock values increase as the risk free rate declines, and lower hurdle rates will encourage business investment and growth when confidence returns. These benefits are part of the reason the stock market has rallied impressively since the S&P 500 hit a low of 667 in March 2009. The index more than doubled in the following 26 months, to 1371 in May 2011, fueled by rising profits and investor expectations that the Fed s QE program would spur growth. The rally faltered during the summer of 2011, with the S&P 500 declining to 1075 because of global economic and political tensions and fears of slowing growth in the US, Europe, and China. The expiration of the first phase of quantitative easing contributed to that correction, too. The announcement of a large, similar program in Europe, the Long Term Refinancing Operation, helped to restore confidence, and the rally resumed in October, with a 300 point gain in the S&P 500 through the end of March. Unfortunately, the index has fallen by almost 150 points since that peak, as renewed worries about Europe are weighing heavily on investor expectations. This volatility is likely to continue until global economic and political conditions improve markedly. Yields Over Time Cumulative Returns 25% 900 800 2 15% High Grade 700 600 500 S&P 500 Treasuries 1 5% Treasuries S&P 500 Dividend Yield 400 300 200 100 Wilshire 5000 Inflation 0 Source: Bank of America Merrill Lynch Source: Bank of America Merrill Lynch 2
Market High yield bonds were among the worst performing fixed income asset classes during the financial crisis, with a loss of almost one-third of their total market value between October 2007 and November 2008. Then, consistent with the historical pattern, they led equities out of the downturn. Uncharacteristically, they continue to have a performance edge three years into the recovery. To a large degree that is because they have directly benefitted from the Fed-engineered decline in underlying risk-free rates. Returns have come in three forms: reliable coupon income, rising bond prices due to falling rates and tightening spreads, and call and tender premiums as issuers refinance at lower rates. Meanwhile, equities have struggled with weak and uneven growth and numerous global concerns. HY Returns and GDP Growth 1987-2012 to lock in historically low borrowing rates and extend maturities. When the primary market reopened after the financial crisis, only better quality high yield issuers were able to access this market. But recently, some low-rated companies have issued bonds, including a small proportion of risky LBO and dividend deals. Even so, the overall quality of the issuance thus far in this cycle has been considerably better than in prior cycles. 6 5 4 3 2 1 Market Ratings Composition % BB % B % CCC Average Quarterly Returns 3.5% 3. 2.5% 2. Source: Bank of America Merrill Lynch Default Outlook 1.5% 1. 0.5% 0. Source: Bank of America Merrill Lynch,U.S. Bureau of Economic Analysis < 0 0-2% 2-4% 4-6% > 6% Annualized Real GDP Growth Historically, the best environment for high yield investors has been slow to moderate economic growth that dampens defaults but does not trigger rising interest rates. We are enjoying such an environment presently. It is not surprising that capital has been flowing into this market at a record pace for most of the past two years, especially considering the very low yields offered by most fixed income alternatives. Supply has easily kept up with that demand, as issuers are anxious Default rates are low and are likely to remain so for the foreseeable future. The market was cleansed of most troubled issuers during 2008 and 2009, when 19% of the US high yield market defaulted or restructured through coercive exchanges. Those that remain, understandably leery of too much debt, have been reducing leverage and refinancing to cut interest expense and extend maturities. As a result, the proportion of the market rated CCC, the group most likely to default, has declined by almost half since its peak during the crisis. Most issuers have been able to push their maturity walls out to 2014 and beyond, thereby delaying a common default catalyst. Also, as previously mentioned, overleveraged borrowers are better able to avoid default when capital is available and rates are low. And even slow GDP growth provides some tailwind for those issuers that need to grow into their capital structures to service their debt. For all those 3
reasons, we expect defaults to remain in a range of 2 3% during the coming 12 18 months, unless oil prices collapse or the economy goes into recession. That compares favorably to the 4.2% long term average. 6% Monthly Default Rate Market strategists generally discount the presence of a yield floor, pointing to the very attractive yield advantage over alternative fixed income securities and the historical record of declining yields. There is a better argument for a price ceiling, since convexity turns negative as prices rise above par and call constraints come into play. We believe the price ceiling is more impenetrable than the yield floor. In either case, gains beyond another three or four points would push prices to historically unsustainable highs, and yields below historic lows. Average Price 5% 110 4% 3% Monthly Default Rate 100 90 104 Price Ceiling? 2% Long Term Average Default Rate 80 70 1% 60 50 Source: Bank of America Merrill Lynch, JP Morgan Chase Source: Bank of America Merrill Lynch Returns Despite the vacillating recovery, high yield investors have enjoyed very good returns since the November 2008 bottom, averaging 24.4% per annum. CCC-rated issues averaged 33.8%. The mean price of the bonds in the Bank of America Merrill Lynch Master Index II reached 102 in February, and has since retreated to about 99. The yield bottomed at just below 7%, and has since risen to almost 8%. The price rarely goes above 103, and the all-time high, 104, has been touched on only a handful of occasions and was never sustained for more than a month or so. The yield is now 125 basis points above its all-time low, 6.75% reached in May 2011, after having tightened to within 25 basis points during the February peaks. With underlying rates near historic lows, we believe high yield bonds will gravitate toward these record yields and prices when markets are bullish. On the positive side, spreads remain munificent, more than compensating investors for the risks inherent in high yield investing in a favorable default environment. The average option-adjusted spread is above 700 basis points. That is about 150 basis points above the historic median and very generous considering the broadly-held, benign outlook for default rates. The excess spread is partly explained by the myriad macro risks to the global economy and financial markets, and partly by investor anticipation that underlying Treasury rates will rise at some point during the life of the existing bonds. Average Yields and Spreads 25% 2 15% 1 5% Source: Bank of America Merrill Lynch 4 Yield to Worst Optionadjusted Spread Median Spread
Effects of Low Treasury Yields on Bond Returns and Correlations For the next year or two, Treasury rates are not likely to rise much from their very low current levels, and are even less likely to decline. The yield of a corporate bond can be viewed as a combination of the underlying risk-free rate plus the spread over Treasuries. The risk-free portion is directly correlated to similar maturity Treasuries, while the spread is a reflection of the creditworthiness of the issuer, issue-specific characteristics, and expected outcomes. The spread is largely correlated with the issuer s equity. Spreads will be the primary determinant of high yield bond prices during this period of stable, low Treasury rates. A worsening economy would lead to wider spreads and lower bond prices while an improving domestic economy, positive resolution of the European crisis, or re-accelerating growth in China could induce spread tightening and resultant capital gains, tempered by the aforementioned price ceiling. When underlying rates are low, the spread is the largest component of high yield returns, and Treasury yields are a relatively small part. That is the case today, as the Treasury accounts for just under 2 of the total yield of the high yield index, and the spread 8. It follows that returns should be more equity-like; that is, more volatile, more correlated to equity indices, and less correlated to Treasuries. If so, these differences should be incorporated into allocation decisions and the portfolio management process. To test this theory, we calculated the returns and volatility of various asset classes during the past 20 to 25 years, and compared those to the period since November 2007, when the 7 to 10 year Treasury index has yielded less than 4%. We excluded the eight months between September 2008 and April 2009, when volatility spiked well-beyond historic peaks as the markets collapsed and rebounded, because we believe those outlying returns are unlikely to recur in the foreseeable future. The results are shown in the table below. Nearly all of the asset classes enjoyed above-average returns as rates came down and markets recuperated. But none came close to the performance of high yield bonds, which were buoyed by the falling rates and by narrowing spreads as investors regained confidence in the economy and the financial system. We expected high yield volatility to increase materially, but that has not been the case. It is only modestly higher than it was before rates came down. That demonstrates the stabilizing effect of the current income stream and, to a lesser extent, the counterbalance from the small Treasury component of its total returns. We find it noteworthy that the Treasury and equity volatilities are the same in both interest rate environments. Asset Class Returns & Volatility, 1987 - Present* 7-10 Year Treasuries 7-10 Year High Grade S&P 500 Wilshire 5000 Average Annual Return 8.74% 7.71% 7.29% 8.44% 7.26% Annualized Volatility 8.56% 6.21% 6.32% 15.69% 15.96% Sharpe Ratio 1.06 1.29 1.19 0.61 0.52 Low Yield Period, November 2007 - Present** Average Annual Return 13.19% 8.79% 10.9 8.64% 6.43% Annualized Volatility 8.74% 6.12% 5.54% 15.79% 16.24% Sharpe Ratio 1.56 1.47 2.00 0.59 0.48 *Monthly data from January 1, 1987 - May 31, 2012, except High Grade (1992-2012) ** Excludes 8 months of severe volatility from September 2008 - April 2009, and 2012 data is as of May 31 Source: Bank of America Merrill Lynch, Bloomberg 5
We also calculated and compared the correlations among the asset classes during the same time periods, with the results shown in the table below. Here, we see the results we expect during the low Treasury rate period: higher correlations with equities, and lower with Treasuries. In the low rate environment, the correlation between high yield and Treasury returns is decidedly negative, at -46%. That is partly because the underlying risk-free rate has fallen to a small portion of the index s yield. More important, the index s correlation with the S&P 500 increased from 58% to 78% as the S&P 500 s correlation with Treasuries became considerably more negative. In fact, Treasury correlations with all of the asset classes fell precipitously. The depth of the negative correlation reflects the risk-on, risk-off nature of the markets during the past year or so, when equities and Treasuries have tended to move in opposite directions. Asset Class Correlations, 1987 - Present* 1.00 7-10 Year Treasuries 7-10 Year Treasuries -0.01 1.00 7-10 Year High Grade 0.55 0.70 1.00 *Monthly returns from January 1, 1987 - May 31, 2012, except High Grade (1992-2012) and VIX (1990-2012) ** Excludes 8 months of severe volatility from September 2008 - April 2009, and 2012 data is as of May 31 Source: Bank of America Merrill Lynch, Bloomberg 7-10 Year High Grade S&P 500 Wilshire 5000 S&P 500 0.58-0.05 0.27 1.00 Wilshire 5000 0.61-0.07 0.26 0.99 1.00 VIX vs. HY Spreads 0.77 1.00 Low Yield Period, November 2007 - Present** 7-10 Year Treasuries -0.46 1.00 7-10 Year High Grade 0.65 0.25 1.00 S&P 500 0.78-0.59 0.29 1.00 Wilshire 5000 0.78-0.61 0.28 1.00 1.00 VIX vs HY Spreads 0.58 We also examined historical correlations, and compared them to Treasury yields as those declined over time. These relationships are displayed in the charts on the following page. The first shows the correlation between the high yield and Treasury indices since 1987, tracked against Treasury yields. While the correlation chart is noisy, there does appear to be a downward trend, particularly during the current period of low underlying Treasury rates. The second chart shows the correlation between the high yield index and the S&P 500, tracked against Treasury yields. This correlation chart is similarly noisy, but there is a discernible upward trend as rates have come down during the past 12 years. 6
/ Treasury Correlations & Treasury Yields / S&P Correlations & Treasury Yields 1.00 12% 1.00 12% 0.80 0.60 0.40 0.20 0.00-0.20-0.40-0.60 1 8% 6% 4% 2% HY/Treasury 1 Year Correlation Treasury Yield (RHS) 0.80 0.60 0.40 0.20 0.00-0.20 1 8% 6% 4% 2% HY/S&P 1 Year Correlation Treasury Yield (RHS) -0.80-0.40 Source: Bank of America Merrill Lynch, Bloomberg Source: Bank of America Merrill Lynch, Bloomberg Efficient Frontier Implications for Allocations We expect that this negative correlation between high yield and Treasury indices is shifting the efficient frontier for portfolios comprised of those securities toward higher potential returns and lower overall volatility, to a small degree offset by the larger volatility of the high yield index alone. To discern the overall effect of these influences, we ran a Monte Carlo simulation to develop forward looking efficient frontiers for the combination of high yield and Treasuries using the correlation coefficient and standard deviations prevailing under each of the two rate environments. We assumed the instruments would return their present yields, less expected default losses for high yield. We also computed corresponding Sharpe Ratios. 7-10 Year Treasuries Current Yield to Worst 7.85% 1.55% Expected Losses - 3% Default Rate 1.8 Annual Return 6.05% 1.55% Historic Volatility & Correlation Annualized Volatility 8.56% 6.21% Correlation -0.01 Recent Volatility & Correlation Efficient Frontier Assumptions Annualized Volatility 8.74% 6.12% Correlation -0.46 7
Treasury & Efficient Frontiers Sharpe Ratios 7% 1.0 Total Return 6% 5% 4% 10 Recent Correlation & Volatility Ratios Sharpe Ratio 0.9 0.8 0.7 0.6 0.5 Recent Correlation & Volatility Ratios 3% 2% 1% 10 Treasuries Historic Correlation & Volatility Ratios 0.4 0.3 0.2 0.1 Historic Correlation & Equity Ratios 0 2 4 6 8 10 Volatility - Standard Deviation of Total Returns 0.0 2 4 6 8 10 Portfolio Allocation The case for combining high yield and Treasury securities is significantly more compelling at current levels of volatility and correlation, since the gains from diversification among these two asset classes are considerably more pronounced. As the charts above demonstrate, the optimum Sharpe Ratio is significantly higher, and it is achieved with a smaller allocation to high yield bonds. By allocating 38% of a Treasury portfolio into high yield, an investor can reduce overall volatility by 4, and double returns to 3.25% from the 1.55% yield of the Treasuries alone. Beyond that, the investor can maximize the portfolio Sharpe Ratio by increasing to a 51% allocation, and can continue to increase returns to more than triple that of Treasuries alone, while still holding volatility below the Treasury index, by putting 76% into high yield. Using the historical volatility and correlation metrics, similar returns are possible, but with significantly more volatility and commensurately lower Sharpe Ratios. We recognize that these ideal high yield weightings are well beyond most investors guidelines, which typically allow only 5% to 2 allocations to this asset class. While the gains from diversification are constrained under those limitations, even at those levels the benefits are more advantageous in the low rate environment. As shown below, moving up from a 5% allocation improves returns, while reducing volatility and enhancing the Sharpe Ratio. Efficient Frontier Inflection Points Historic Volatility & Correlation Allocation Return Volatility Sharpe Ratio Recent Volatility & Correlation Allocation Return Volatility 10 Treasuries 1.55% 6.21% 0.25 1.55% 6.12% 0.25 Minimum Volatility 35% 3.12% 5.01% 0.62 38% 3.25% 3.7 0.88 Maximum Sharpe Ratio Maximum Return at Treasury Volatility Sharpe Ratio 68% 4.62% 6.13% 0.75 51% 3.85% 4.06% 0.95 69% 4.65% 6.2 0.75 76% 4.96% 6.11% 0.82 10 10 6.05% 8.56% 0.71 10 6.06% 8.73% 0.69 Typical Allocations 5% 5% 1.78% 5.92% 0.30 5% 1.78% 5.42% 0.35 1 1 1.98% 5.64% 0.35 1 2.0 5.16% 0.39 2 2 2.44% 5.24% 0.47 2 2.46% 4.37% 0.56 8
Implications for Portfolio Managers Low Treasury rates are likely to persist for another year or two, and longer if the economy continues to struggle to grow beyond the current slow rate. This is a positive environment for high yield bonds, especially because defaults are likely to remain suppressed. While the outlook for rates and the economy remains benign, it makes sense to reach down the credit quality spectrum to enhance yields by purchasing well-researched, improving credits that offer attractive value relative to their risk. When conditions deteriorate, the market s excess spread should cushion initial losses and provide a window to reposition the portfolio. If the primary concern is rising rates, we would shorten duration and move toward the middle of the ratings curve, to reduce exposures to rising rates inherent in BB-rated bonds and to equity volatility inherent in CCC-rated bonds. If the concern is an economic downturn and rising defaults, we would move up the quality scale to lessen exposure to downgrade and default risk, and we would shorten duration to reduce overall portfolio volatility. That said, our investment process is primarily focused on bottom-up fundamental analysis designed to identify securities which offer positive alpha. Alpha is always in style for high yield investors, but in this environment, where overall market returns are somewhat limited, alpha is one of the two best ways to enhance returns and outperform the index. The other way is to avoid defaults and downgrades. Both have the added benefits of reducing volatility and lowering correlations with equities and Treasuries. Conclusion Chairman Bernanke s statements indicate that the Fed intends to maintain low rates for at least another two years. We conclude that these low baseline rates will have important repercussions for high yield investors, beyond the obvious impacts on yields for these bonds and for fixed income alternatives. In the current low rate environment, high yield investors must contend with limited upside, higher correlations with equities, and negative correlations with Treasuries. At the same time, they can benefit from generous spreads that more than compensate for likely default losses. We have adjusted our management approach to incorporate these conditions, and we suggest that large fund managers re-evaluate their high yield allocations in light of the changes in efficient frontiers that we present in this paper. To wit, our analysis indicates that the gains from diversifying into high yield are more pronounced in this low rate environment. We recommend that investors capitalize on this opportunity to improve returns and reduce volatility by increasing their allocations into well-managed high yield bonds. Mike Brown Co-Portfolio Manager Robert Paine Co-Portfolio Manager 9
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