High-yield bonds have been a part of the investible universe since the early 1980s, when Wall Street began popularizing the asset class. Back then, high-yield securities, or junk bonds, as they typically were called, were being touted for their attractive return characteristics.
Many investors rushed in, dazzled by the return possibilities. But there is never return without risk, and the recession of the mid-1990s decimated many investors. Therefore, many investors consider the asset class too risky; they also can point to the additional circumstances of last year, when U.S. high-yield bonds significantly underperformed U.S. high-grade bonds. However, there is a definite case for inclusion of high-yield bonds as an asset class in most institutional investors' portfolios.
Many investors mistakenly believe high-yield bonds are issued by companies on their last legs or in distressed financial condition, the so-called "fallen angels." While some issuers fall into this category, many are new companies that don't have borrowing histories or companies electing to leverage their assets to finance growth, enhance their equity value or complete acquisitions. In fact, many established, successful companies issue high-yield bonds, including household names such as Apple Computer Inc., Avis Rent A Car System Inc. Continental Airlines Inc. K mart Corp., Nextel Communications Inc., Samsonite Corp., TV Guide and Vail Resorts Management Co.
The asset class is broadly diversified across the global economy. The Lehman Brothers U.S. Corporate High Yield index, a popular high-yield index, showed as of June 30 29% in communications, 19% in consumer cyclicals, 13% in consumer non-cyclicals, 9% in capital goods, 8% in basic industries and the remainder in a variety of other sectors. High-yield issuers can be found in all sectors of the economy.
High-yield also is a large and growing segment of the U.S. market, comprising more than 4% of the Lehman U.S. Universal index as of June 30. As of that date, there was more than $750 billion in outstanding issuance, having grown at an annualized growth rate of approximately 17% in the past 20 years. It is expected to continue to grow rapidly.
Not to be ignored
Thus it is not an asset class that investors simply can ignore and, moreover, there are specific reasons investors should have a high-yield asset allocation in their portfolios.
Long-term attractiveness: High-yield bonds offer an opportunistic way to add value. They have produced extremely attractive returns over the long term. High-yield bonds absolutely have outperformed the broad high-grade fixed-income market, as measured by the Lehman High Yield index vs. the Lehman Aggregate, in 12 of the past 16 years and have had negative returns in only three of those years. This includes last year, when the underperformance was quite spectacular at 1,750 basis points. The underperformance of high yield during 2000 was clearly due to the unfolding slowdown in the economy. Until the recent terrorist attacks, a recovery beginning in late 2001 seemed probable. The market is undergoing a repricing of systemic risk, which is negatively affecting both the equity and high-yield markets. Thus, 2002 also might prove to be an unattractive year for high-yield returns. Nonetheless, longer term, high-yield returns remain attractive with a 9.7% annualized return for the Lehman High Yield Index for the 10 years ended June 30, compared with a 7.9% annualized return for the Lehman Aggregate index.
Potential for high returns: High-yield bonds can add additional return potential to a portfolio, especially now with yield spreads having widened significantly last year. A comparison of the yield spread of the average Lehman Brothers High Yield index yield over the yield of similar maturity Treasury bonds is compelling, with a yield advantage of almost 800 basis points as of June 30. Yields have tightened since the end of last year as investors have responded to these attractive levels, but they still remain at very wide levels historically. The longer term normal yield advantage appears to be closer to 400 basis points.
Low correlation with other investments: High-yield bonds offer excellent portfolio diversification for investors. This is because high-yield bonds exhibit such low correlation with other bond classes. For instance, based on the 10-year period ended June 30, high-yield bonds have only a 0.21 correlation with 10-year T-bonds and a 0.33 correlation with high-grade corporate bonds. Even in comparison with equities, a class to which high yield frequently is compared, the diversification effect still holds. High-yield bonds have only a 0.36 correlation with the Standard & Poor's 500 index and 0.35 with the Russell 2000. In fact, while "there is no such thing as a free lunch" in the investment markets, it could be argued the diversification benefits of high-yield bonds do offer a "free dessert" since adding high-yield bonds to a portfolio of high-grade U.S. bonds can reduce risk and increase return. Using data for the 10 years ended June 30, a combination of 70% U.S. high-grade bonds (as represented by the Lehman Aggregate) and 30% high-yield bonds (as represented by the Lehman High Yield) would have increased return by approximately 30 basis points while reducing risk (as measured by annualized standard deviation). This is shown in the accompanying graph.
Active management
The case for investors' using high yield as an asset class in a diversified portfolio is therefore quite strong and is based on an analysis using a high-yield benchmark. One final fact about the high-yield universe makes it an attractive asset class for investors: active management can add significant incremental returns over passive benchmark returns. Using Callan Associates' high-yield style universe, the Lehman High Yield index has returned in the third or fourth quartile for the three-, five- and 10-year periods ended June 30. Contrast this with high-grade bond or large-cap equity universes, where active managers vs. the Lehman Aggregate or S&P 500 have had a much more difficult time outperforming their benchmark. This is one asset class where it definitely pays to have active management.
In conclusion, despite investors' inclination to avoid an asset class that historically has been called "junk" and clearly is more risky than other classes of U.S. fixed income, the return profile and diversification possibilities demand that sophisticated investors consider using high-yield bonds in their portfolios. These investors will be richly rewarded over time.
Patrick St. A. Lyn is U.S. fixed-income product specialist at WestAM, Houston.
