Burdened with negative labels, high yield bonds are often perceived as low quality and high risk. Investors may be surprised to learn that many of the companies whose bonds are rated “below investment grade” are, in fact, well-established and well-known businesses that have been operating profitably for decades. An investor holding a diversified portfolio of equities may already be exposed to a high yield issuer’s balance sheet and, therefore, has implicitly accepted the business case behind high yield companies.
Research shows that high yield bonds can offer a yield premium—with only a marginal increase in credit risk and a lower level of interest rate risk. Moreover, while investors are concerned about absolute levels of risk, only a small percentage of bonds rated “below investment grade” actually default. In fact, the difference in default rates between the lowest rated investment grade bonds and the highest rated non-investment grade rated bonds is less than 1 per cent.
Size matters
The U.S. high yield bond market is three times the size of the entire Canadian corporate bond market in both size and number of issuers. By including global high yield bonds, investors can capture greater diversification benefits by expanding their investable universe. Importantly, it is common for passive investment strategies (as well as investment policies) that rely on credit ratings to prohibit high yield bonds. This creates structural market inefficiencies that can be exploited by active managers, and are particularly evident at the “crossover area” on the credit curve (BBB versus BB).
If we separate a pension plans’ assets into two categories—a growth portfolio and a risk-mitigating portfolio—pension plans are quickly realizing that global high yield is the one asset class that can fit into either the higher yielding portion of the risk-mitigating portfolio and/or the lower risk portion of the higher returning growth portfolio.
When de-risking, some plans have considered using high yield in place of equities in their growth portfolio because long-term returns have been similar in the two asset classes, with significantly less volatility in high yield bonds. Global high yield may also play a return-enhancing role for the risk-mitigating side of the growth portfolio without materially adding to volatility. Most core plus strategies have an allocation to global high yield to accomplish this. However, active management is important when considering a dedicated global high yield or a core plus allocation, because quality is paramount.
Ultimately, investors can benefit from the risk-adjusted returns this asset class can add to a pension portfolio.
Nicholas Leach is vice-president, global fixed income, CIBC Asset Management