THE P&I 1,000: High-yield inflows continue despite talk that risks are too great

Most big U.S. pension funds with allocations in high-yield bonds poured more money into the asset class in the 12 months ended Sept. 30, but a growing minority said valuations have risen to the point where risks there now outweigh the potential rewards.

According to Pensions & Investments' annual survey of the top 200 U.S. pension funds, plan sponsors had a combined $50.2 billion invested in high-yield bonds as of Sept. 30, up a hefty 27.3% from the previous year. Even adjusting for the 12.6% rise recorded by the Lehman Brothers High-Yield index, the assets showed a healthy gain.

Market watchers said both short-term and longer-term factors were at work. "Some of this was opportunistic," with yields of less than 4% for U.S. Treasuries pushing investors into higher-yielding instruments, but the increase also reflects the structural trend of institutions moving to diversify their asset mixes, said Alistair Lowe, director of global asset allocation with State Street Global Advisors, Boston.

Michele Cunningham, the head of fixed-income investments with the California State Teachers' Retirement System, Sacramento, said both factors contributed to the 80% surge in CalSTRS' high-yield bond holdings, to $2.37 billion as of Sept. 30.

The fund made its first allocation to the asset class in 2002 and came close to its target — 6% of overall fixed-income holdings — by 2003, but it left room to hold more or less depending on market conditions. With mainstream bonds offering such meager yields in 2004, "we were definitely putting money" into high yield bonds last year, Ms. Cunningham said. CalSTRS' high-yield allocation was roughly 8.5% of its fixed income holdings as of Sept. 30, she said.

CalSTRS wasn't alone. Many big pension funds that had large high-yield bond holdings as of Sept. 30, 2003, also put even more money into the asset class in 2004. These include:

c General Motors Corp., Detroit, which increased its high-yield holdings by 34%, to $8.2 billion;

c the New York City Retirement Systems, New York, increased its high-yield holdings by 71%, to $4.1 billion;

c the Massachusetts Pension Reserves Investment Management Board, Boston, up 149%, to $2.5 billion;

c the Florida State Board of Administration, Tallahassee, up 40%, to $1.6 billion;

c the Teacher Retirement System of Texas, Austin, up 43%, to $1.5 billion; and

c the Wisconsin State Investment Board, Madison, up 104% to $1.2 billion.

While an increase in high-yield bond holdings was not entirely unexpected, the scale was larger than some analysts had anticipated. With pension funds struggling to get the investment returns they need, it's no shock that money was going into high-yield bonds, said Brian Birnbaum, the head of fixed-income research with consultant Ennis, Knupp + Associates, Chicago.

Still, considering the sharp narrowing of the premium high-yield securities offered over Treasuries during the course of 2004, the scale of that 27% increase "surprises me a bit," he said.

For some observers, it's just the latest example of investors chasing returns long after the pickings have ceased to be lush. The strength of high-yield inflows, even at these "historically tight spreads," continues to drive up valuations and lower returns, said an executive with one Midwest public pension fund, who declined to be named.

Some analysts said pension funds should be wary about the asset class even if there's no sign yet that it is cruising for a financial bruising. "We think high-yield bonds will outperform (investment-grade bonds) this year," but the question is, "how much risk are you taking to get that compensation?" said Michael W. Roberge, chief fixed-income officer with MFS Investment Management, Boston.

At this point, the risk isn't negligible. High-yield bonds are yielding 300 basis points or so over Treasuries, and while there's no reason to panic just now, clearly the "next big move in spreads is going to be wider, not tighter," said Mr. Roberge. A widening would imply a selloff as investors demand a fatter markup over Treasury yields for holding high-yield bonds, leaving existing portfolios facing capital losses. Investors may be able to bank that 300-basis-point premium for the next year or two, but if sentiment turns, they can lose that advantage "in no time at all," he said.

High-yield bonds may remain a good place to be in 2004, but pension funds should still cash in some of their winnings and put that money into other asset classes that have logged lesser gains, agreed Michael Rosen, a principal with pension consultant Angeles Investment Advisors, Santa Monica, Calif.

That's what Angeles has already begun doing for the pension fund clients that have given it discretion to make investment decisions on their behalf, Mr. Rosen said.

Some of the top 200 pension funds are doing the same thing. For example, the Pennsylvania Public School Employees' Retirement System, Harrisburg, Pa., cut its high-yield bond holdings by 12% in the 12 months ended Sept. 30 — to $1.02 billion — "because of the narrowing in yield spreads, which resulted in reduced return expectations for the asset class," said spokeswoman Evelyn Tatkovski. Another reason for the cut was that the strong performance of the asset class over the past few years had lifted the fund's high-yield holdings above its target range, she said.

Other funds reporting decreases in their high-yield bond holdings in 2004 included:

c the San Francisco City and County Employees' Retirement System, San Francisco, down 46% to $334 million;

c the Illinois Municipal Retirement Fund, Oak Brook, down 9.7% to $595 million; and

c the Teachers' Retirement System of Louisiana, Baton Rouge, down 5.2% to $734 million.

Even funds that poured money into high-yield bonds in 2004 said they might have enough for now. After such a brilliant run, it's tough to expect as much in the future, said CalSTRS' Ms. Cunningham. In 2005, CalSTRS is more likely to be looking for opportunities to trim its holdings in the asset class, she said.