Making High Yield Corporate Bonds Work For You

Transcript
Jose Garcia Zarate: Hello, I'm Jose Garcia Zarate, Senior ETF Analyst with Morningstar. Investor interest in the high-yield corporate bond market has been growing quite substantially over the past year, and this has been duly reflected in punchy inflows into the ETF market. To talk about ETFs and the high-yield in particular, I'm here with Ryan Blute, product manager for corporate bonds with PIMCO in London.

Ryan, thank you for being here.

Ryan Blute: Thank you for having me.

Garcia Zarate: Perhaps we should start with sort of like a brief definition of what high yield actually is, and then go into explaining the reasons why investors are putting their money into this asset class right now?

Blute: A simple explanation for what high-yield corporate bonds are is just to think of them just like your favourite traditional corporate bonds. So, traditionally, people think of investment-grade corporate bonds—so very high-quality, low default risk corporate bonds from companies like BMW or Pfizer. High yield corporate bonds are no different other than that they are lower credit quality companies, and the rating agencies define what is ‘investment grade’ and what is ‘high yield’. So, high yield bonds begin at BB+ and investment grade companies end at BBB-. So once you enter that BB+ segment of the market and below, you're in high-yield corporate bonds, but they're just traditional fixed-rate corporate bonds issued by large and small companies around the world.

Now this segment of the market is really attracting a lot of attention today in high yield because of two primary reasons. The number one is that we see central banks, especially in developed world, anchoring short-term rates at very low levels. So, if you're an investor whether an individual or an institution, you're earning very little on your cash today in your money market accounts or in your deposit, and so investors are searching for yields. In the high-yield market today, we yield almost 9%. You compare that to less than 1% in your average short-term deposit. You are taking on more risk [in high yield] but investors need yield and they need return. So this is one way that they are pursuing that return.

The other reason we're seeing flows into this segment of the market is that investors are seeing high yield as an attractive substitute for equities. So with the yield on the market today of almost 9% investors say ‘well, that's kind of roughly what I would hope to get over the long run from my equity portfolio. Here is an opportunity to reduce equities, move into high yield, and keep that same level of potential expected return, but benefit from the much lower volatility of high yield.’ So, high yield has historically had about half of the volatility of equities, but if you look back to the mid-1980s through today, it's returned 96% of the S&P 500 return. So, from a risk return perspective, investors actually think this is a great asset class which perhaps they are underinvested in.

Garcia Zarate: Right. So, how sustainable do you think this positive trend is going to be in the medium term to long term because eventually, sort of like, you have to assume that monetary conditions might normalise?

Blute: Right. Sure. So, you need to think about the macro economic conditions and then central bank policies to assess whether this makes sense or not. And from our perspective at PIMCO, we certainly believe that central banks will be at very low levels of interest rates in the developed world for a prolonged period of time to help us get nominal growth going again, and to keep liquidity in the financial system. So that means you're going to see these very punitive short-term interest rates for cash deposits. So from a technical perspective that continues to provide demand for assets that give you a yield, dividend yields are fairly low today, but you get that nice coupon from investing in high yield.

From a macroeconomic conditions standpoint, we've done some studies looking at the returns of equity markets, let's say using the S&P 500, versus high yield in various growth environments. So you could look at very weak, but still positive, real growth or slightly negative real growth, and in those environments high yield—and particularly short-term high yield—has done better than equities and the big reason for that is you get a nice coupon as your foundation for return as a high-yield investor. You're getting coupons of 5% to 7% whereas dividend yields are very low.

So if you believe that we're going to be in a weak growth environment, which means earnings growth will be weaker, then you perhaps are not going to have the same capital gains that you need in equities to get you to that high level of expected return. Whereas in the high-yield market you have a bit of a cushion because you get this very large component of your total return from coupon payments or interest income. And so, from that perspective, we think the demand is going to be fairly sustainable for assets which give you a decent yield and certainly a positive after-inflation yield which you can't find in many elements of the bond market today.

Garcia Zarate: Okay. Well, PIMCO has been with in partnership with Source in the development and marketing of fixed income ETFs and one of your latest additions is actually the PIMCO Short-Term High Yield Corporate Bond Source ETF which gives you exposure to the short-term segment of the US high-yield market, high-yield bond market. So the question I think from a European perspective is why short-term and why US high yield?

Blute: Sure. Okay. So, let's tackle the US question first because this is an important nuance to make sure investors understand. The US high-yield market really just means bonds issued in US dollars and that makes up more than 80% of the market overall. So from a certain perspective, you could say the global high-yield market really is almost entirely the entire US high-yield market. So that's one thing to understand, but then it's also important to understand that just because it's issued in dollars does not mean that it's an American company. So there are Continental European, there are UK-based companies that borrow money in the US dollar market because it's the biggest and most liquid part of the high-yield market globally. So, when you invest in a dollar-denominated high-yield portfolio, you actually do get some exposure to companies domiciled outside of America. So that's the first thing to understand.

The second thing really is the segmentation or clientele affect, when you think about investing across the maturity spectrum in high yield or just on that short-dated part of the curve. So in our particular strategy we focus on the zero- to five-year part of the curve which really gives you a different risk in return profile than your traditional full maturity high-yield investment.

So, one difference is the sensitivity to changes in spreads. So if you invest in a traditional high-yield portfolio and the market goes down, meaning spreads go up, then you're going to lose roughly 4% to 5% all else equal as those spreads widen. You're going to have roughly half of that affect in the short segment of the market, where you have a lower average maturity and therefore lower spread sensitivity, and we saw this take place in the month of May where both markets were down, but you had a much lower decline in that short-dated segment of the market because that lower sensitivity to changes in spreads.

So investors should really think about segmenting their investments between short-dated and full maturity. We've seen some clients who wanted to still have some risk exposure, but dialed down risk a bit, focused on this short segment of the market. We've seen other investors who’ve said ‘I tier my cash into certain buckets, and I want to have a little bit which gets me some more juice or some higher potential return’; they will use that short segment of the higher market as a way to enhance their potential return on their cash investments as a small addition to safer and more, what you might call, bulletproof investments for their cash portfolio.

So there is a number of ways you could use the short segment of the higher market, but it's important to understand that it is quite different, and therefore complementary and not a substitute for the full maturity high-yield market.

Garcia Zarate: Okay. High yield in its natural state is actually a fairly opaque market and the beauty of it, so to speak, of ETFs is actually to provide easy access to all kinds of asset classes in your portfolio, to all kinds of investors. So from the point of view of a fixed income practitioner, how would you say that high yield fits into an investment portfolio?

Blute: Sure. I think high yield is an asset class which you first want to think about the asset class and then what vehicle do you want to choose to express your investment view. So from an asset class perspective, high yield we think makes a lot of sense versus equities. I mentioned half the volatility roughly the same return over 20+ years. So from a certain perspective you could say investors are underinvested in high yield, and it can enhance the efficiency from a portfolio efficiency standpoint of their portfolio. The other thing to think about is then the vehicle, so do you want to have the daily liquidity, intraday liquidity and the full transparency you get on a daily basis of an ETF vehicle? The next, the beauty, as you say, of this particular wrapper or this fund structure, is you get access to the holdings on a daily basis and if you want to express a view, either risk on or risk off, the ETF vehicle allows you to do that.

Now, ETF—high-yield ETFs—have certainly been growing in popularity over the last couple of years, but it's important to put their size in perspective. We have roughly $30 billion of assets in high-yield ETFs right now. That compares to a market which is over $1 trillion. So, on a flow basis, they have become much more popular and they are winning the race in terms of where are the flows coming from, but on a stock basis, they are still quite small relative to the market overall. Another key thing to take into account is that the high-yield market has historically been a market sponsored in a great deal by individual investors. So that's really not changing things then, whether they pick to use a daily NAV fund or an intraday liquidity fund via an ETF, you still have that same buyer base it’s just the vehicle is changing slightly.

Garcia Zarate: Right. Okay, so I think probably we agree that perhaps the good thing about ETFs is actually providing access to this asset class, which might be opaque but could be quite interesting for an investment portfolio. Thank you very much for your comments…

Blute: Okay.

Garcia Zarate: …Thank you very much for listening.