Should the high-yield bond market get a permanent piece of a plan sponsor's pie? SEI Capital Markets Research says it should, and recently recommended clients keep 10% to 30% of their fixed-income portfolio in high-yield bonds.
SEI makes the recommendation based on research showing the high-yield sector's low correlation to other sectors can reduce risk, while providing greater returns than typical fixed-income securities. Also, SEI argues high-yield bonds should be a separate asset class, based on their distinct return, risk and correlation statistics.
The recommendation comes after more than three straight years of solid returns from both the high-yield sector and its managers. The median high-yield manager in Pensions & Investments' Performance Evaluation Report has an annualized returned of 19.9% for the three years ended March 31. At the same time, the Salomon High Yield Index rose 17.37%, annualized, and the Salomon Broad Bond Index rose 9.1%.
While other consultants recognize the benefits of investing in high yield, they are less likely to suggest a sponsor put 30% of fixed income into that sector.
Moreover, they noted some plan sponsors won't or can't invest in high-yield securities. Some plan sponsors may be limited by plan guidelines to investment-grade securities, bonds that are rated BBB or greater by the two major ratings agencies, Standard & Poor's Corp. and Moody's Investors Service Inc., both in New York. Other sponsors may be wary of junk bonds because of the market's well-publicized collapse in 1989 and 1990, and the securities' association with Michael Milken and the now defunct bond house Drexel Burnham Lambert.
Despite the high-yield market's negative associations, Victoria Rainsford, vice president and head of fixed-income research for SEI, said a sponsor could add about 20 basis points of return without adding risk by putting 10% of its fixed-income portfolio in high-yield, or junk, bonds. SEI estimates the volatility would remain unchanged, around 7%, for both a portfolio of 100% traditional fixed-income securities, and a portfolio of 90% traditional and 10% high yield.
As an investor's allocation to high-yield rises above 10%, the sponsor's expected return would continue to climb at a rate favorable to its increase in risk, until an allocation of 30% of fixed income is reached. Above 30%, the risk-return trade-off begins to work against the high-yield investor.
Ms. Rainsford said SEI tried to be as conservative as possible in its assumptions about volatility and expected return, and still ended up with results that suggest a permanent allocation to junk bonds makes good investment sense.
SEI's research notes a high-yield allocation of less than 10% of fixed income would be beneficial to a sponsor from an investment perspective, but might not be great enough to overcome the administrative costs of adding another asset class.
Kingman Penniman, executive vice president and director of high-yield research in the Montpelier, Vt., office of Duff & Phelps, said SEI's research is another indication that the junk-bond market has established itself as a viable means for institutional investors to earn higher returns.
"It's taken a long time, but (high-yield bonds) are in fact being recognized as an asset class that everyone should own," he said.
Mr. Penniman said issuance is expected to grow in the near future, as firms continue to access capital, using junk bonds as an alternative to privately placed debt or bank debt. High-yield securities are favored over private debt in regard to their lower issuance costs and less-restrictive covenants, he said. In addition, junk bonds generally aren't used to fund leveraged buy-outs as they were in the 1980s, which should make them more attractive, he said.
Mr. Penniman noted many institutional investors already invest in junk bond types of securities through private placements, but don't necessarily recognize them as such. "From an investment perspective, I don't see a difference" between the two, he said.
As institutional investors continue to recognize the junk bond market no longer is used to finance takeovers, and that returns can be enhanced as risk is reduced, the market should gain more acceptance.
"High yield has its proper place in the asset allocation mix," Mr. Penniman said.
SEI's Ms. Rainsford said an SEI position paper on the subject has garnered a lot of interest from sponsors and clients. SEI hasn't added high-yield managers to its fund-of-funds, but is in the process of doing so, she said.
Other consultants said the benefits of junk bonds always have been available as a way to increase diversification of a portfolio, while adding return. Because of the negative publicity surrounding high-yield bonds around the turn of the decade, plan sponsors either are wary of investing in them, or are afraid of being associated with them.
Investment consultant Wilshire Associates Inc., Santa Monica, Calif., has consistently recommended their use since 1987, said Stephen L. Nesbitt, senior vice president and principal. For sponsors willing to use them, they can add 100 basis points to 200 basis points over the Lehman Brothers Aggregate Bond Index, he said.
Mr. Nesbitt said Wilshire is not likely to recommend that a sponsor put much more than 10% of its fixed-income allocation into junk bonds because that probably would cause the fund's total junk bond allocation become too high. For example, if a sponsor had a 60/40 mix between equities and fixed income, a 30% junk bond allocation would lead to a 12% overall allocation to high yield, which is higher than Wilshire would suggest, he said. Among Wilshire's clients that invest in high-yield bonds, between 2% and 3% of the total portfolio is what they'll usually put in that sector. And they wouldn't go above 5%, he said.
And George Oberhofer, director of fixed-income research for Frank Russell Corp., Tacoma, Wash., noted the high yield share of the overall fixed-income market is probably less than 10%. Russell's clients most likely only would go higher than that when making a tactical call regarding the high yield market, he said.
At Callan Associates Inc., San Francisco, high yield is perceived as a way to add diversification and return, but is not well-received by clients.
"Not a lot of our clients are opting to use them," said Margaret Latartara, vice president. While Callan doesn't have a consultant solely devoted to that asset class, its consultants do meet with and evaluate high-yield managers, she said. Nonetheless, Callan has performed only one high-yield manager search in the last four years.
"We work with some clients who just plain don't want them in their portfolio."
In the instances where a Callan client is investing in junk bonds, usually it is on an opportunistic basis, as opposed to a set allocation. When a manager can add value by being in the sector, it will do so, Ms. Latartara said. But Callan wouldn't necessarily mandate the sponsor be in high-yield bonds at all times.
For instance, a sponsor's core fixed-income manager may dip into BB rated bonds, depending on market conditions.
She said it is much more common for Callan's clients to try to aim for the benefits of high-yield securities, of diversification and return, by moving into international fixed income, she said.
If a client were neutral regarding the use of junk bonds, Callan would recommend either international fixed income or high-yield bonds and let the client decide, she added.
When a sponsor does decide to move assets into junk bonds, SEI notes manager selection is important. That's because the variance of performance among high-yield bond managers can be wide. Results in PIPER support that. In the first quarter of this year, the breakpoint for the fifth percentile in the PIPER high-yield universe was 4.5%, while the 95th percentile return was -5.3%. Similarly returns in 1993 ranged from 33.9% for the top 5%, to 11% for the bottom 5%.
PIPER is compiled by Rogers, Casey & Associates, Darien, Conn.