For managers, investors high yield back on the upswing

Investment managers are extending their high-yield bond capabilities in the U.S. and abroad as investors globally are reaching for better risk-adjusted returns with lower volatility, all within the confines of a zero-interest-rate environment.

As an asset class that straddles fixed income and equities, high yield is attracting investors from two camps — those chasing a higher risk/return profile for their fixed-income strategy and those searching for a less volatile equity surrogate, consultants said.

“U.S. high yield, relative to other (investment) options, is still paying interesting returns with potential for further appreciation,” said Daniel Celeghin, partner at Casey Quirk & Associates LLC, Darien, Conn., which advises money managers on business strategies. “There's a real hunger for higher returns, and no obvious place to get those returns.”

Inflows are far from the levels seen in 2009, when there were 454 high-yield hires totaling about $35.2 billion following the bankruptcy of Lehman Brothers Holdings Inc., according to data from Eager, Davis & Holmes LLC, Louisville, Ky.

In 2011, the number had dropped to 212 mandates totaling $27.8 billion.

But evidence suggests investments in high yield are holding their appeal and trending upward, with more investors seeing the asset class as “a strategic part of the institutional asset mix compared to the tactical bets implemented a few years ago,” said Dik van Lomwel, managing director and head of Europe and the Middle East at Neuberger Berman Europe Ltd., London. The firm had $15.2 billion in high-yield strategies as of Dec. 31.

“Just as we saw in 2008-2009 in the aftermath of Lehman Brothers, spreads widened in October (2011) well above fair value. At the same time, the fundamentals of the market remained strong — significantly stronger when compared to the 2008-2009 period,” said Michael Brownell, vice president and product manager on the high-yield team at Pacific Investment Management Co. LLC, Newport Beach, Calif. “The volatility in the third quarter of last year presented investors with an attractive entry point into high yield.”

While institutional inflow data for the first two months of 2012 are not available, consultants and managers said they're seeing positive indications for overall growth. As of Feb. 22, the latest figures available, year-to-date overall inflows into U.S. high-yield mutual funds and exchanged-traded funds were about $13.8 billion, with about 40% invested through ETFs. In comparison, inflows for all of last year totaled $15.6 billion, with about 35% invested through ETFs, according to data from Lipper Inc., New York.

At BlackRock Inc., inflows through high-yield ETFs totaled $2.7 billion so far this year compared to $3.5 billion for all of last year, said Matthew Tucker, managing director and member of the product strategy team within BlackRock's fixed-income portfolio management unit in San Francisco. BlackRock manages a total of about $40 billion in high-yield assets globally.

“There are two main routes to access the high-yield market,” Mr. Tucker said. “One way is through the over-the-counter market, which through a variety of forces has seen less liquidity support by broker-dealers, so the supply (of high-yield corporate bonds) that investors can access has gone down substantially. On the other side is the growth of the high-yield ETF market, which has essentially created another layer of liquidity” for institutional investors.

High-yield investments are still dominated by U.S. investors, but Europe is catching up. Unstable equity markets as a result of the eurozone crisis have made U.S. assets — including high yield — more attractive to European institutional investors, sources said. In addition, alternatives, including hedge funds, haven't performed as well as many investors had expected, said Andrew Feltus, senior vice president and high-yield portfolio manager at Pioneer Investments, Boston, which has about $15 billion in high-yield assets under management.

James Trask, investment partner at consultant Lane Clark & Peacock LLP, London, said the firm is currently advising several U.K. corporate pension funds on adding high-yield exposure, many of which have no exposure to the asset class. He declined to name the funds. Mr. Trask added that to have a meaningful impact on overall portfolio performance, investors should allocate at least 5% to high yield.

“We're seeing (investors) who don't have exposure to high yield examining high yield to complement their portfolios,” said Andrew Junkin, managing director at Wilshire Associates Inc., who is based in Denver. “Investors are looking at high yield as perhaps a less risky — and lower return — equity surrogate. We have not seen anybody looking to cut high yield.”

For the 10 years ended Dec. 31, 2011, the Credit Suisse High Yield Index returned about 9.07% on an annualized basis, compared to a 2.92% annualized total return for the S&P 500 during the same period. Furthermore, high-yield bonds — generally defined as subinvestment-grade securities rated below Baa3 by Moody's Investors Service and BBB- by Standard & Poor's or Fitch — have been about half as volatile as the S&P 500 over the same time.

“Investors got burned last year for a second time (since the 2008-"09 financial crisis), and to some degree they're learning the lesson that high yield is a very good substitute for equities, although (the opportunity set) is nowhere nearly as large,” Mr. Brownell said. PIMCO's dedicated high-yield strategies have doubled in AUM over the past three years.

While high yield is clearly more risky in terms of default risk compared to government bonds, “the additional potential for returns is more than adequate compensation for the additional risk,” Mr. Trask of LCP said.

Entry points are important for high-yield investors, and spreads have already compressed compared to where they were late last year, sources said. “If the economy continues to strengthen, given current spread levels, it will be difficult for high yield to compete with (returns from) a robust equity market,” said Glenn Davis, partner at manager consultant Eager, Davis & Holmes.

Alternatively, if stock markets weaken, “high yield is fairly highly correlated to equities, so from current spread levels, investors are starting to ask what level of defensiveness will it provide,” Mr. Davis added.

Traditionally, investors have included high yield in their fixed-income strategy, but “that's a mistake,” said Gershon Distenfeld, senior vice president and director of high yield at AllianceBernstein LP, New York.

The right way of thinking about the asset class is to think of equity-like returns with less volatility, Mr. Distenfeld said. AllianceBernstein had about $20 billion in high-yield AUM globally at the end of 2011, twice what it had three years ago.

Over the past three decades, the correlation between high-yield bonds and investment-grade bonds has been about 0.3, compared to about a 0.56 correlation to the S&P 500, according to Mr. Distenfeld. AllianceBernstein extended its range of high-yield offerings by launching a higher-quality, shorter-duration strategy in the second half of 2011.

Managers with high-yield capabilities are widening their footprints, particularly investing in distribution both in the retail and institutional sectors within the U.S. and abroad, said Mr. Celeghin of Casey Quirk. “It's hard to think of any (high-yield manager) who's not expanding.”

Both BlackRock and PIMCO have added capabilities as well as new high-yield strategies over the past year, most notably in exchange-traded funds aimed at institutional and retail investors in the U.S. and Europe. Russell Investments and State Street Global Advisors also have filed applications to introduce high-yield ETFs.

Elsewhere, managers are opening new offices overseas partly in response to local client demand for high-yield strategies. Earlier this year, fixed-income boutique Rogge Global Partners, London, opened an office in Frankfurt. Since the beginning of 2011, Neuberger Berman has opened offices in Milan, Frankfurt and Buenos Aires. In Europe, the firm also launched a short-duration high-yield strategy in December 2011.

Better known for its equities capabilities, MFS Institutional Advisors is making a big push into credit both in the U.S. and Europe. “We wanted to leverage our global research capabilities. Our equity guys already talk to the credit analysts across the globe, and we can build from that,” said Carol Geremia, president and co-head of global distribution at MFS Boston. MFS has about $3.6 billion in high-yield AUM, or about a 35% increase over the past two years.

“The fundamentals of high yield have certainly changed,” she added. “Corporations are managing their balance sheets much better, and certainly better than some governments.”