24 May 2019
Francis Chua, Fund Manager
Being active in high yield doesn’t necessarily mean taking on more risk. But risk management isn't all about reducing risk either. How should investors strike this balance?
High yield bonds are a common feature in diversified portfolios today. They have historically had a low correlation to government and investment grade bonds, and have the potential to offer higher spreads. But with this comes the risk of higher defaults and therefore greater volatility.
As an asset class, high yield is relatively illiquid which makes it difficult for index replication without excessive tracking error and transaction costs. Index strategies in high yield therefore usually seek to replicate benchmarks that represent only the most liquid portion of the universe. There are a number of ways that an active high yield manager would seek to manage risks and add value.
The first is via the liquidity/illiquidity premium. Active managers can participate in the more liquid names but are not forced to. Dynamically managing this within a portfolio can help to add value but as with all things, there should be a balance. Managers with illiquid portfolios have the prospect of higher returns on paper but run the risk of being unable to meet liquidity requirements in times of stress.
Managers can also look to manage risk dynamically via a portfolio’s exposure to the different rating bands. Our analysis of the IA High Yield sector shows that the 'average manager' has been reducing allocation to below single B (and unrated) securities, whilst increasing the allocation to BBs and cash. This could be driven by a general reduction in risk and/or as a result of the change in credit quality of the universe. The net result is an improvement in credit quality for investors.
What is interesting to us is that we’ve not seen a material increase in risk taking from managers this year despite the improved market backdrop. Is this because high yield managers are generally defensively positioned anyway?
The average high yield manager is underweight BBs, overweight single Bs and underweight the lower-rated bands (CCCs and lower) relative to the BofAML global high yield index. Investing in CCCs and below comes with higher risks in the form of higher default rates and lower liquidity. In addition, many managers will have guidelines restricting the amount invested into this space.
Given the underweight to CCCs, one could argue that high yield managers are defensive versus the index. The corollary of all this is that if fund selectors are also focused on relative returns, then it will be worth looking at how defensively positioned (or otherwise) a manager is versus its peers.
The second corollary is managers are likely underperform the index in years when CCCs and lower rating bands generate strong positive returns. While we wouldn't expect managers to shy away completely from CCCs, we also shouldn't expect managers to invest a significant amount in CCCs as the risk of default is higher. Having a balance is important.
The US makes up a large part of the universe but increasingly, non-US bonds are taking a bigger slice of the junk bonds pie. In 1998, there were only 11 issuers listed on the BofAML European High Yield Index – today that number is north of 400. This growth presents global high yield managers with a growing opportunity set to invest in. We expect that as the market grows, more and more managers will allocate away from the US.
Returning to the earlier point about risk, it is not necessary to just move up in credit rating quality if the goal is to reduce portfolio risk. Besides the obvious allocation to cash, a manager can also improve diversification by increasing the allocation to non-US high yield. Back in the early 2000s, European high yield default rates were higher than the US but since 2012, the reverse has been true. Similarly, emerging market high yield bonds have had lower default rates than the US over the last three years.
Why does all of this matter? Perhaps a quotation from Oaktree Capital's Howard Marks sums it up best:
“We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favourable ones.”
In high yield, the risk of default drives the need to be defensive. As we’ve seen above, managers are generally taking less risk than the index and have a number of tools at their disposal to actively manage risk. However, being defensive is not synonymous with taking no risk. Balance is important – being too defensive or aggressive may mean sacrificing return potential.