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When a high yield can be too high – beware the triple-Cs

13-03-2014 | Insight | Sander Bus The search for yield can come at a price if investors chase bigger returns without factoring in the extra risk involved, warns Robeco’s Sander Bus.

Speed read:
  • Spreads have narrowed with sovereign bonds
  • Some investors now chasing yields in CCC
  • Not enough reward for the extra risk taken

The returns on high yield corporate bonds have progressively come down, for two reasons. Firstly, interest rates have gradually risen, which means bond values fall. In addition to this, the spread – the difference between credit yields and those of benchmark government bonds - have shrunk. This makes them relatively less attractive to government bonds for investors who look to bank the difference contained in the spread.

To compensate for this, many investors are now chasing the higher returns available in bonds with lower credit ratings, but they are not being sufficiently compensated for the extra risk, says Bus.

His Global High Yield Bonds fund applies a conservative approach in its investment style, meaning that it focuses more on the better-quality names within the high yield universe and thus has an underweight exposure to the riskier names that would fall in the CCC-rated category. The fund prefers to build exposure to the BB and B-rated corporates, which are below investment grade but carry a relatively lower chance of default than the triple-C category.

credit-spreads-between-corporate-and-government-bonds.jpg
How credit spreads between corporate and government bonds have fallen over the past year. Source: Bloomberg.

Price for taking risk is too high
“We aim to get the best possible returns for investors, but there comes a point when gaining a high yield comes at too high a price in terms of the risk taken,” says Bus.

“Triple C’ is a category where returns are high but the risks are also higher. We believe that there is insufficient compensation in that segment for the risk you are taking. It is now wise to largely avoid over-exposure to this segment, because when the market turns, triple-C is expected to be the underperforming category.”

“Current spreads just don’t justify investing in triple-C bonds. If you look at the default and recovery rates, you are not rewarded for the average default scenario in CCC,” says Bus.

“They’ve returned more in the past, but at this phase in the cycle, it is unwise to put too much store in them now. It’s a mistake that some investors make when they focus on return targets and not on risk. We should perhaps just all accept that returns will be lower all round in 2014, thanks to improving economies and tapering leading to the end of easy money, and not chase the most risky bonds.”

The supply of such bonds has increased lately as private equity sponsors take advantage of the strong high yield market by selling tempting types of bond when they take companies private. “We are seeing more issuance of bonds rated triple-C and also Pay-in-Kind (PIK) notes, where you don’t get cash interest but additional nominal (face value) in the bonds. This is increasing risk on the balance sheets of companies.”

credit-rating-scale
The credit rating scale: CCC is defined as ‘currently vulnerable’. Source: Standard & Poor’s

Maturities and durations are key
It is possible though to be more selective within an existing fund universe without compromising returns or risks, he says. At the moment, spread curves are pretty steep, which means an investor gets relatively more return in bonds that take longer to mature, when they must be repaid by the issuer. Put simply, switching to longer-dated bonds by extending average maturities in the portfolio gives you more pick-up.

“Usually the high yield market has pretty flat spread curves, where owning longer-dated bonds does not make much difference to yields. So extending maturities is a good means of picking up more spread against sovereigns,” he says.

Investors though have tended lately to go in the other direction, demanding bonds with shorter durations because they fear that interest rates will rise. If this happens, the bonds become progressively less valuable, so it can make more sense to buy the securities that take less time to mature.

"However, it’s much smarter to hedge your interest rate risk if you are afraid of a high duration than to chase lower duration bonds,” says Bus. Low-duration funds take out the rate risk but also reduce the available spread. Someone who invests in high yield bonds ultimately wants to be exposed to the spread.”
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