Pension funds are pouring money into high-yield fixed income, even though the best part of the ride might be over.
In the first quarter, half of all placements and 70% of all fixed-income dollars placed went to high yield, compared with 28% of all placements and just 8% of fixed-income dollars placed in the first quarter of 2002, according to Mercer Investment Consulting's Tracker database.
Overall, Mercer recorded $2.3 billion placed in high-yield fixed income in the first quarter, more than twice the amount placed in the asset class in all of 2002, said Robert Stein, analyst for Tracker.
In 2002, U.S. institutional tax-exempt assets invested in high yield jumped nearly 16%, to $87.6 billion, from the previous year, according to data collected for Pensions & Investments' annual money manager survey.
The sudden interest stems from strong performance. Year-to-date through April 30, the Lehman Brothers High Yield index is up 14%. For the six months ended April 30, the index is up 22.75%; for the 12 months, 8.8%, according to Lehman Brothers.
In a marketplace that's thirsting for positive return, the asset class has been an oasis in a desert. "It's not necessarily a great renaissance for the asset class," said Phillip Maisano, chief executive officer at Evaluation Associates Inc., Norwalk, Conn. "It's a reach for yield."
`Focused on yield'
"Investors are very focused on yield in this low interest rate environment," said David Hammerstein, chief strategist at Yanni Partners, Pittsburgh.
In recent weeks, high yield has cooled off as spreads have narrowed. "What looked like a good idea at the beginning of the quarter looks like less of a good idea in May 2003," said Jack Malvey, chief global fixed-income strategist at Lehman Brothers, New York.
But while the asset class might not approach 20% returns over a six-month period anytime soon, Mr. Malvey and others believe high-yield bonds could bring high single-digit or low double-digit returns over the next few years and outperform Treasuries and investment-grade bonds.
"It's not fundamentally seamless, but it's a market that has a little more to it, to be sure," added Mr. Malvey. "The best part of the ride has taken place, but there's still some (return) left out there."
Robert Gish, director of investments for the New Mexico Public Employees Retirement Association, Santa Fe, agrees. The $8 billion pension fund is looking to invest in high yield for the first time. "In the environment we're in, it could prove to be an asset class where there is considerable opportunity coming off the equity bubble and a downward trend in interest rates," he added.
Mr. Gish said the plan is to put 3% to 5% of the assets into high-yield fixed income to diversify the portfolio. "Like all asset classes, there are periods of time when it is in favor and out of favor," he said. "That's where diversification comes in."
The board has not determined where the money will be shifted from, but it probably would come out of fixed income, which makes up 40% of the pension fund. The search most likely will take place in the third or fourth quarter, he said.
Best at the beginning
It's been awhile since the high-yield asset class has been strong. Going back to 1998, high yield bonds have underperformed Treasuries and high-grade bonds. High-yield bonds have struggled because default rates have climbed steadily through the late 1990s, the result of the over-investment in technology and the recession of the early 2000s, said Bruce Walbridge, high-yield portfolio manager at State Street Global Advisors Inc., Boston. Default rates peaked at 11.5% in early 2002 and have dropped steadily since, hitting 5.8% in April 2003. "High yield has historically performed best at the beginning of an economic recovery, when we experience declining default rates and improvement in pricing," said Mr. Walbridge.
But because of the incredible inflow of cash in the last few months, the market became a little overheated, Mr. Walbridge added, as prices increased and returns flattened out a bit. Nonetheless, he thinks the market is still at the beginning stages of a good run. "I look for a coupon-clipping environment over the next 12 months or so," with returns in the 8% to 12% range, he said.
"This is a long-term return opportunity in the high-yield market," said Christian Noyes, senior vice president at Penn Capital Management, Cherry Hill, N.J. As of Dec. 31, Penn managed $236 million of U.S. institutional tax-exempt clients, of which $179 million was in high yield bonds.
Most of the returns will be with B and CCC bonds, said Mr. Noyes, as opposed to the higher grade BBs. Investment-grade bonds and higher rated high-yield bonds will be at a disadvantage in a rising interest rate environment, he said, while bonds rated B and lower will trade more on company fundamentals as companies look to refinance and upgrade.
Consultants say more pension executives are carving out a separate asset class for high-yield bonds, rather than lumping them in a core-plus bond portfolio.
"It's an asset class that fills a strategic role," said Danielle Muller, co-head of fixed-income research at Rocaton Investment Advisors LLC, Darien, Conn. "Over the long term, we look for it to fit in a strategic allocation between long-term U.S. equity and fixed income."