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Fixed-Income Insights

Adding equity to a high-yield bond portfolio may enhance returns without adding significant risk.

Although the high-yield asset class has been around for approximately 40 years, we find that it is still somewhat misunderstood in the minds of both institutional and retail investors. Some may classify it in their “fixed-income basket,” while some may avoid the asset class altogether and instead view it as “riskier” than equities. The fact is, if you look at the asset class in its entirety, high yield falls on the risk spectrum between fixed income and equities. While the Barclays U.S. Aggregate Bond Index has delivered the most attractive risk-adjusted performance over the last 10 years, the return of the high-yield market compares quite favorably when you move farther out on the risk spectrum. In fact, the annual return of the high-yield market over that period has nearly matched that of the S&P 500® Index, but with only about two-thirds of the volatility.

 

Chart 1. As an Asset Class, High Yield Sits Midway on the Risk/Reward Spectrum between Fixed Income and Equity
10-year historical data, as of 12/31/15 

Source: Zephyr and Lord Abbett.
1BB High Yield as represented by the BofA Merrill Lynch BB U.S. High Yield Index. 2B High Yield as represented by the BofA Merrill Lynch Single B U.S. High Yield Index. 3CCC High Yield as represented by the BofA Merrill Lynch CCC & Lower U.S. High Yield Index.
Past performance is not a reliable indicator of future results. The historical data shown in the chart are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

However, we also believe it is important to drill down into the high-yield asset class, as represented by the BofA Merrill Lynch U.S. High Yield Index, and look at the risk/reward proposition across the ratings spectrum. When we do this, we see that the bulk of the volatility comes from the ‘CCC’ rated portion of the market, without a commensurate uptick in return. The amount of credit risk in the ‘CCC’ portion of the market is much higher than the ‘BB’ rated space, evidence of which is reflected in historical returns and loss rates. The return profile for ‘CCC’ rated credits is even less attractive when we examine their performance during recent history. Over the past five years, for example, ‘CCC’ credits have posted returns of a little more than 2% versus about 12.5% for the S&P 500, with comparable volatility.  On the other end of the spectrum, ‘BB’ credits have the most attractive risk/reward profile in the high-yield market over the last 10 years. In fact, ‘BB’ credits posted returns almost identical to that of the S&P 500, with about 60% of the volatility. To be fair, ‘BB’ credits did see some benefit from a meaningful decline in Treasury yields over that time period.

Another common misconception is that adding equities to a high-yield portfolio will make it “riskier.” In this report, we will look at the risk/reward dynamic of the ‘CCC’ portion of the high-yield market relative to equities, and then examine the impact of adding a modest amount of equity risk to a high-yield portfolio. While we found that the risk-adjusted returns actually can be improved by substituting ‘CCC’ credit with equities, we also found out that, in practice, adding equity risk to a high-yield strategy does not necessarily increase the beta of the portfolio relative to the benchmark. In addition to the return benefits, equities also can enhance the liquidity of a high-yield portfolio, thereby allowing a manager to express sector themes he or she may not have had access to in the high-yield credit markets.

‘CCC’ Credits—The “Junky” Part of the High-Yield Market
When we consider the concept of enhancing the performance of a high-yield portfolio with equities, the case starts with examining how unattractive is the ‘CCC’ rated portion of the high-yield market as an asset class unto itself. Back in the formative years of the high-yield market, the asset class often was referred to as the “junk” bond market. When, however, we consider the 10-year data in Chart 1 and how well the asset class as a whole has performed on a risk-adjusted basis over its history, this may be a bit of a misnomer. Yet for the ‘CCC’ sector, the term “junk” definitely applies. Over the last 30-plus years, the average loss rate for ‘CCC’ credits has been more than three times higher than the market average and that of their slightly higher rated ‘B’ rated peers (see Chart 2). While the ‘BB’ and ‘B’ rated sectors have had years when no credit losses have been taken by investors, even in its best year (1994), the ‘CCC’ sector experienced losses greater  than 1%. In fact, dating back to 1983, credits at the lowest rung have had eight years when credit losses exceeded 10%.  This is the key reason why the return profile of ‘CCC’ credits has been so unfavorable relative to the upper tier of high yield and equities over the last several years. Even though ‘CCC’ rated issuers are just a notch lower than single-‘B’s, the increase in credit risk, as you move down the ratings spectrum, is significant. This is one of the many reasons that we tread carefully into the ‘CCC’ market and rely on our experienced analyst team to distinguish which bonds are attractively valued high-yield credits and which are “junk.”

 

Chart 2. ‘CCC’ Credit Losses Dwarf Rest of High-Yield Market
Credit loss rates, 1983–2015*

Source: Moody’s. Moody’s is an independent, unaffiliated research company that rates fixed-income securities. Moody’s assigns ratings on the basis of risk and the borrower’s ability to make interest payments.
The historical data shown in the chart are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.
*Based on issuer-weighted average default rates and issuer-weighted senior unsecured bond recovery rates.

 

Now that we have determined where ‘CCC’s fit on the risk/reward spectrum versus the broader high-yield market, let’s see how they look when we compare the risk/reward profile to equities. For our analysis, we examined the performance of ‘CCC’s and the mid-cap space relative to the high-yield index (as represented by the BofA Merrill Lynch CCC and Lower U.S. High Yield Index). We chose the Russell Midcap Index due to the fact that the average market cap for public high-yield issuers is about $10 billion, placing them near the top of the mid-cap category.  

Over the last five years, the mid-cap space wins hands down over ‘CCC’s when we look at both absolute and risk-adjusted returns, with a Sharpe ratio of 0.87 for the Russell Midcap Index versus 0.21 for the ‘CCC’ index. If we go back 10 years, which includes the financial crisis of 2008–09, equities still look better than ‘CCC’ credits, albeit by a smaller margin. One other important statistic to note is the fact that the downside capture for ‘CCC’s is worse than that of equities in both time periods—that is, when high-yield market returns have been negative, losses in the ‘CCC’ space were even greater than if one had been invested in the equity market.

 

Table 1. Historically Equities Have Posted Better Risk-Adjusted Returns Than the ‘CCC’ Sector

Source: Zephyr and Lord Abbett.
Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Blending Equities and High Yield
Before we discuss the Lord Abbett approach to using equities in high-yield portfolios, we first want to examine the approach using index data. For this analysis, we decided to invest 90% of the portfolio in a ‘BB’/’B’ high-yield index (i.e., no ‘CCC’s) and 10% in the Russell Midcap Index. Looking back 10 years, we would have a portfolio that actually shows slightly more defensive characteristics than investing in the high-yield index, with lower beta, slightly better risk-adjusted returns, and lower downside capture. However, over the past five years (January 2011—December 2015), the 90/10 portfolio has a much more attractive return profile in both absolute and risk-adjusted metrics. This makes sense, given our earlier analysis that highlighted that mid-cap equities have a more attractive return profile than the ‘CCC’ sector of the high-yield market.

 

Table 2. High Yield - 'CCC’s + Equities = Potentially Attractive Returns

Source: Zephyr and Lord Abbett.
Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Diversification does not guarantee a profit or protect against loss in declining markets.

 

The Lord Abbett Approach: How Equities Can Fit into a High-Yield Strategy
Now that we have considered how equities, in theory, may enhance the performance of a high-yield portfolio, it is time to discuss how they fit into Lord Abbett’s high-yield strategies. In addition to the data cited earlier, there are a few other key reasons why we utilize equities in high-yield strategies, including:

  • Liquidity—If we want to de-risk our portfolios, it is much more efficient to sell equities than attempt to sell ‘CCC’ credits, which can be less liquid than ‘BB’ and ‘B’ rated credits. This can be especially helpful for our mutual funds, which tend to see outflows when volatility increases in the financial markets.
  • Express sector themes—On occasion, we may develop industry sector themes that may be difficult to express within the high-yield market. For example, in late 2014, we developed a positive view on the airline and casual dining sectors due to the decline in energy prices. However, both of these sectors represented only a small portion of the high-yield index at the time. While we did go overweight each sector via credit purchases, we also bought several stocks to help enhance this theme.
  • When ‘CCC’ valuations are tight—We tend to approach the ‘CCC’ space with caution, given some of the performance data cited earlier in this report.  In order to go overweight this section of the market, we would need to see very compelling valuations relative to the broader high-yield market. However, when the risk/reward is not favorable in the ‘CCC’ space, we still can efficiently add risk via the equity market.

One common concern that we hear from clients is “your strategy must have a much higher beta versus the index due to the equity exposure.” However, when we look at the historical data, that is not the case.  In fact, late last year, when our high-yield fund’s equity/convertibles exposure was near 8%, the beta for the strategy was actually slightly lower than the benchmark high-yield index. Keep in mind, though, that over the last 10 years, ‘CCC’ credits actually have had a higher beta versus the high-yield index than have mid-cap equities.

 

Chart 3. Rolling 12-Month Beta and Equity/Convertibles Exposure

Source: BofA Merrill Lynch and Lord Abbett. Past performance is no guarantee of future results.

 

Conclusion
The knee-jerk reaction that many investors might have when they see equities in a high-yield portfolio is totally understandable. Further, if you look at equity returns relative to the BofA Merrill Lynch U.S. High Yield Constrained Index, stocks do appear to be a riskier proposition. However, when you compare them to the highly volatile ‘CCC’ space, a strong case can be made for investors who have an appetite for flexibility and risk. To be clear, this additional flexibility must be used judiciously, and requires a commitment to rigorous company research and risk management by the investment manager. Fortunately, this is a process that we have perfected at Lord Abbett during our 40-plus years of experience in the leveraged credit markets.

 

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