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The high-yield problem

Investments
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By Nimisha Srivastava and Mike Fontaine | September 1, 2020

Capturing alpha in an area where many underperform.

Dispersion. Informational advantage. Market inefficiencies. All of these phrases can be used to describe high-yield bonds, an asset class that should be ripe for alpha. Yet, 75% of high-yield bond managers fail to beat the benchmark on a net-of-fees basis.1

While high-yield bond investing has become increasingly popular over the past decade, long-term alpha generation in the asset class is difficult. In addition, all-in yields within the asset class are low relative to history despite a large repricing event in March, thus increasing the importance of alpha as part of total returns. In this brief, we explore several challenges traditional high-yield mandates face, and propose two ways asset owners can help improve the outcome of their corporate credit portfolios over the long term, namely through a dedicated exposure to fallen angels and a more focused approach to traditional bottom-up active management.

High-yield indices — tough to beat

Like their equity brethren, high manager fees have been a key contributor to why it has been difficult for many high-yield managers to outperform the benchmark. The average standard fee for a high-yield bond mandate is approximately 50 basis points, which can eat up a substantial amount of outperformance.2 Another significant issue is transaction costs, which are elevated relative to other parts of fixed income and can materially affect compounded returns (particularly as the index does not experience these costs). It is one of the reasons why high-yield exchange-traded funds (ETFs) have underperformed broader market indices over longer time periods given the need to continually rebalance to closely match the index (and why most ETFs track a more liquid subset of the market). Recent market research suggests that the round-trip transaction cost of a high-yield bond is normally between 100 and 200 basis points, a number that is prone to significant spikes in volatile environments like that of March 2020.3

The solution: So what can an investor do? Given the challenges noted, we believe high-yield mandates could be significantly improved by embracing two key elements as drivers of long-term alpha.

  1. 01

    Fallen angels: A best-kept secret

    In our view, fallen angels have been one of the best kept secrets in fixed income investing. Whilst much attention has been paid to the significant threat they pose to investment grade portfolios, far less attention has been paid to the opportunity they present to investors who are willing to look past short-term dislocation towards long-term value.

    In short, fallen angels are issuers that were once rated “investment grade” but have since been downgraded by enough rating agencies that they are now considered “below investment grade.” Many market participants in fixed income have strict rules around both the nature and amount of below investment grade credits they can hold. These restrictions often result in forced selling from some of these participants such as index funds, investment grade only funds, insurance companies and pension plans. In addition, many boutique managers in the high-yield space still do not cover these names to the same degree as they cover originally issued high-yield companies, which can potentially lead them to have material underexposure to this subset of bonds.

    We believe the best kept secret is that this forced selling causes the bonds to enter into the index at depressed levels. By employing a disciplined approach that buys the bonds only as they enter into the index, investors can potentially realise significant outsized returns relative to their risk (Figure 1).We believe the depressed pricing appears to be a result of the market overreacting to downgrade news (via forced selling), with many of the underlying companies being brand names that are highly motivated to return to investment grade status in the long run. Even in absence of a long-term upgrade, as the technical selling pressure subsides it creates an opportunity for the bonds to recover in value above an investor’s purchase price.

chart depicting performance of fallen angel bonds and BB indices
Figure 1- Cumulative excess return over treasury Fallen angel simple average vs. BB index October 2004 - December 2019

Data source; Bloomberg Barclays Indices, Mellon Investment Management. Year-to-date data as of 30/06/2020. Figure 1 represents all bonds that were downgraded from investment grade (as measured by Bloomberg Barclays US Corporate Index) to high yield (as measured by Bloomberg Barclays US Corporate High Yield Index) from the period Oct. 2004 – Dec. 2019. The average return of those bonds’ subsequent 12-month return was compared with the Bloomberg Barclays US Corporate BB Index. Past performance is not a reliable indicator of future returns.


chart depicting return differential between fallen angels and high yield indices
Figure 2- Total return differential – US High Yield Fallen Angel Index 3% Cap minus US High Yield 2% Issuer Cap Index

Data source; Bloomberg Barclays Indices, Mellon Investment Management. Year-to-date data as of 30/06/2020. Past performance is not a reliable indicator of future returns.

Fallen angels have the ability to materially outperform the broad high-yield market in time periods with significant downgrades, such as 2009 and 2016 (Figure 2). This phenomenon has also occurred year to date in 2020, which we expect to continue throughout the rest of the year. We believe a dedicated fallen angels mandate can be a valuable component of a robust corporate credit portfolio, particularly in the current environment with market participants expecting a large amount of fallen angels in the coming years. Recently announced support from the Federal Reserve could be a positive for the strategy as it may place an upper bound on where spreads could widen, though it could also limit the alpha potential if prices do not fall materially before index inclusion. We are closely monitoring the effect that this support has on the asset class, and we would note that the program as currently constructed is scheduled to only run through December 2020.

  1. 02

    Focused high-yield portfolios: “Best ideas” only

    The very nature of fixed income investing is one of asymmetric risk/return; you loan someone money in the hope you get it back, clipping coupons along the way. Therefore, many high-yield managers have adopted strategies to limit downside risk (in particular defaults) by diversifying portfolios heavily. While this can help mitigate the cost of defaults, it also may inhibit alpha potential; the more bonds you hold in the universe, the more you’ll behave like the universe. The average number of holdings across high-yield managers is large, in excess of 2804, but when questioned, do managers really believe that all 280 of these holdings are a “best idea”?

    Our preferred implementation is a more focused approach. Instead of asking one manager to run a heavily diversified portfolio, we pair multiple high conviction managers to own portfolios of 30 to 40 names each. Figure 3 illustrates the concept, resulting in an overall portfolio that still provides diversification but seeks to isolate positions to only the highest conviction names across managers. Key to this process is ensuring that managers of different styles and focuses are paired up to improve the reach of the overall portfolio and avoid overly concentrating in any single name.

Graphic showing that the typical high yield approach is made up of over 280 positions, whereas WTW asks managers to just use their best 30-40 ideas.
Figure 3 – Typical vs Willis Towers Watson Preferred approach

While some overlap is inevitable, a diversified mix of managers with different styles helps create a robust portfolio that can cut out “filler holdings” while increasing the impact that best ideas have on investment outcomes.

Whilst some overlap is inevitable, a diversified mix of managers with different styles helps create a robust portfolio that can cut out “filler holdings” while increasing the impact that best ideas have on investment outcomes. This is a very similar approach to our Better Equities mandate: Both have a fundamental belief that skilled security selection drives long-term alpha. However, investors need to have a tolerance for higher tracking error as well as the ability to allow managers significant leeway in guidelines (e.g., quality, sector); therefore, it may not be the best single approach for lower governance asset owners or those otherwise constrained by regulatory rules to only the highest rated portion of the high-yield market.

Environmental, social and governance (ESG) and sustainability integration are critical to the investment process for this mandate given the focus on a smaller subset of names; managers should have a heightened emphasis on understanding all potential risks to an investment from an ESG perspective. However, because the portfolios are more concentrated, one could argue that better, more productive engagement with companies could occur, as these companies are likely to represent material exposure across a manager’s platform.

High-yield versus loans

We are currently more cautious on the bank loan market than high-yield. Rather than allocate through a dedicated loan portfolio, we instead allow our high-yield managers who are also skilled in loans to have a small allocation to the space if they see attractive opportunities.

The dynamics of the bank loan market have drastically changed in recent years, with fundamentals materially weakening as illustrated in the rise of “covenant lite” loans and aggressive use of other features, such as EBITDA add-backs. While the asset class does benefit from being at the top of the capital structure, there has been a rise in loan-only issuers in recent years, reducing this benefit. These market changes lead us to expect weaker recoveries in loans than in the past. Indeed, we have seen this begin to materialise, with the average recovery rate in default falling from 70% in 2013 to just under 50% in 2019.5

From a market technical perspective, retail mutual fund outflows have been a significant headwind since 2018. Many investors have reassessed their allocation to this asset class as the market expects a low interest rate environment for the medium term (reducing the floating rate benefit of loans). The marginal buyer of loans continues to be CLOs, whose issuance is highly cyclical to the economy and market conditions.

Other opportunities

Whilst the two opportunities outlined cover a wide area of the leveraged finance market, a severe and prolonged default cycle could offer up additional opportunities with distressed specialists. Manager selection in the distressed space is key; with well-known players having an ability to raise tens of billions of dollars in capital, more disciplined approaches may ensure that your “alpha” isn’t just disguised “beta”. Implementation is also critical; while you may naturally pick up some element of “distressed” in a fallen angel or focused high-yield mandate, certain areas of distress may require a longer time horizon and significant lockup of assets.

Conclusion

High-yield investing has gone mainstream, but long-term alpha generation is scarce. We think investors are better served thinking outside of market conventions. By including a dedicated exposure to fallen angels and focusing on traditional bottom-up active portfolios, we think asset owners can improve outcomes for corporate portfolios in the long term.

Disclaimer

Willis Towers Watson has prepared this material for general information purposes only and it should not be considered a substitute for specific professional advice. In particular, its contents are not intended by Willis Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this material should not be relied upon for investment or other financial decisions and no such decisions should be taken on the basis of its contents without seeking specific advice

This material is based on information available to Willis Towers Watson at the date of this material and takes no account of subsequent developments after that date. In preparing this material we have relied upon data supplied to us by third parties. Whilst reasonable care has been taken to gauge the reliability of this data, we provide no guarantee as to the accuracy or completeness of this data and Willis Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any errors or misrepresentations in the data made by any third party.

This material may not be reproduced or distributed to any other party, whether in whole or in part, without Willis Towers Watson’s prior written permission, except as may be required by law. In the absence of our express written agreement to the contrary, Willis Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on this material or the opinions we have expressed.

Footnotes

1 Calculates the 25th percentile return on a 10-year and 15-year basis as of 31 March 2020, for the eVestment “US Corporate High Yield” universe, as compared with the Bloomberg Barclays US Corporate High Yield. To calculate net of fees return, assumes standard fees for a $100 million mandate of 50 basis points.

2 Average fee for a $100 million segregate account mandate across 207 products in the eVestment “U.S. Corporate High Yield” universe.

3 “Market Liquidity Snapshot April 2020,” Barclays Bank PLC.

4 Average of “Current number of bond issues” as of 31 March 2020, across all managers within the eVestment “US Corporate High Yield” universe

5 Morningstar and JP Morgan. “The Rise and Fall of Bank Loan funds,” https://www.morningstar.com/articles/986178/the-rise-and-fall-of-bank-loan-funds

Past performance is not a reliable indicator of future returns or risk reduction.

Authors

Senior Director - Investment Research

Director – Investment Research

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