Fri, 19 Apr 2013
Favorable fundamentals and better yields relative to other fixed-income assets make high-yield bonds worthy of a long-term allocation, but investors shouldn't try to time the market and must ratchet down their return expectations, say T. Rowe Price High-Yield manager Mark Vaselkiv.
Jason Stipp: I'm Jason Stipp for Morningstar.
It's the Future of Fixed Income Week on Morningstar.com, and today we are talking about the high-yield market with manager Mark Vaselkiv of T. Rowe Price High-Yield. That's a Silver-rated fund by our Morningstar analysts. He is going to tell us a bit about what he is seeing and what he thinks is the future of the high-yield area of the fixed-income market.
Mark, thanks for calling in.
Mark Vaselkiv: Jason, I look forward to the conversion.
Stipp: Let's talk about the fundamentals of high-yield. What does the financial strength and the default rate of high-yield issuers look right now? What's the fundamental underlying metrics that you are looking at?
Vaselkiv: Most high-yield companies are in very good shape, and we've enjoyed a period over the last five years of significant balance sheet repair from 2008 through the middle of 2013. Most of our companies have been able to obtain new financing and repair balance sheets that were very stressed five years ago, and that has resulted in a default rate that's near the low among historical averages. And we expect that defaults for the next several years will only be about 1% per annum, and that's a very favorable environment to invest in high-yield securities.
Stipp: Do you think that there are potential trouble spots, for example, if rates started to tick up, would that make it difficult for some of these issuers to renew their debt or roll over their debt?
Vaselkiv: No. The good news is that, there is only about $275 billion of bonds maturing in the high-yield market through the end of 2015. So over a 2.5 year period, the maturities have been extended; the largest annual maturity year I think now, is 2021. So, most companies are in pretty good shape and have locked-in low interest rates for a lot of seven-, eight-, and 10-year financing.
Stipp: Let's talk about the yield on high-yield bonds. So the spread levels of high-yield to Treasuries may be within historical norms, or close to historical norms. But the absolute level of yield that you are getting on the high-yield index, for example, is 5% or less than 5%. At that absolute level, do you think that investors are really getting compensated for the risks that they are taking on in high-yield?
Vaselkiv: It's a tough question, because this is the first time in the history of managing the fund--I have now been the portfolio manager at T. Rowe High-Yield for 17 years--and we've never seen the yield dip below 5%. And to be honest, there are many securities in our space that are yielding well below that. Many of the highest-quality companies now have bonds at 3.5% to 4%. So that starts to concern us, particularly, if those lower-yielding bonds are longer in maturity and have more duration, and as a result carry more interest rate risk.
If you have a 4% bond that will likely be called or mature in two to three years, that's a different type of instrument. And that's probably OK given the fact that short-term rates are almost zero. But we would argue that a 4.5% 10-year bond--and many good-quality BB rated companies can borrow at those rates today, that carries with it a lot of interest rate risk that perhaps investors need to be aware of.
Stipp: It's a very interesting situation, I think, with fund flows and those low yields that you are seeing in high-yield. So investors are obviously looking for yield somewhere, and we've seen that the higher-yielding categories, even now at absolute levels are pretty low, are still attracting quite a bit of investor attention and money.
So my question is, what's the right reason for an investor to consider high-yield in the current environment? What's the wrong reason? Investors seem to like this asset class? So, are they doing it for the good reasons?
Vaselkiv: I hope so. We believe in the long-term power of compounded interest, and I think that's one of the reasons why this asset class has been so successful. And we found that investors who have been willing to endure the periodic years of volatility and losses and hang in there with a long-term allocation to high-yield bonds have done quite well.
And when we look at the 10-year average of high-yield funds--and this is off of your Morningstar universe, off of your webpage--the category average over the past 10 years is 8.4% per year, and compare that to the Barclays U.S. Aggregate Bond Index, which is a good measure of investment-grade performance--that's at 5.1%. So the average high-yield fund has outperformed investment-grade debt by over 3% per year over a decade, and that's been an extraordinary run, even with a difficult year like 2008, where the average fund lost 25%.
So I think one of the dangers of high-yield investing is trying to time the markets, and we understand that investors need to dial up or dial down their high-yield exposure based on where they are in the cycle. But I think it's important that people take a longer-term perspective on this, particularly if you can find a good mutual fund in high-yield that has good credit experience, and the power of that compounded interest really works in your favor.
Conversely, I think the second part of your question is, don't try to be a market-timer. I think very few people were smart enough to sell their high-yield funds in the middle of 2007, and then get back into the market in January of 2009, when the market was at rock-bottom. It takes a tremendous amount of discipline and courage. So, we tell our investors to stick with the high-yield market and just think about it over that five-, 10-, or maybe even 15-year perspective. However, that will be harder now with yields only at 5%.
Stipp: So, to that point, Mark, you mentioned some of the performance statistics over 10 years are pretty impressive, and very similar statistics, even in the more recent times, a 9% annualized return for high-yield mutual funds over the last five years. Should investors ratchet down their expectations for returns in this asset class from that 9% level looking forward?
Vaselkiv: Absolutely--the gains we've enjoyed over that period involve a lot of capital appreciation. We were able to buy many bonds trading at discounts, in some cases substantial discounts, to par, and as companies saw their fundamentals improve, the prices of the underlying securities went up. Today, the average dollar price of a high-yield bond is well north of 100 cents on the dollar, so there really is limited capital appreciation potential.
I think a good manager that can still find some special situations and maybe invest in some complementary areas can tease out a little bit more capital appreciation to supplement the 5% income stream that we talked about. But 5% to 6% annually is probably a reasonable expectation. Jason, I would highlight, though, that's still a whole lot more attractive than any other fixed-income alternatives.
High-quality bond funds struggle to earn 2% in today's environment. And we recognize that many investors need income in a low-interest-rate environment. So, I think that's still a strong reason to remain in this market, because it's one of the few places where you can get reasonable income in this type of an environment.
Stipp: Mark, last question for you. You mentioned that a good manager can find some opportunities, incremental opportunities, although the market as a whole perhaps doesn't look particularly attractive to go full-in. So I have a question for you: Your fund is close to new investors right now. What does that say about the opportunities that you are seeing to put money to work? Is it just tougher to find the kinds of opportunities that you normally would like to find, and hence you've closed the fund to some of the money that might have been coming in?
Vaselkiv: That's true. A big part of our asset class is the enormous amount of underwriting of new high-yield bonds that's been done in the last year and half. Almost $500 billion of new securities since the beginning of 2012, and today it's a sellers' market. The companies and the investment banks realize that there's a lot of demand for higher-yielding instruments. So, they can price those securities at very low coupons.
And because we've closed our fund, we don't have to play aggressively in those new issues. We can turn our analysts loose to find existing securities that maybe are off the radar screen, and sometimes that involves looking at more international companies or looking at some special situations. Some of our best bets in the last six months have been in distressed companies. We had a huge win in buying American Airlines bonds while they were in bankruptcy, and they doubled in value.
So those are the kinds of ideas that are harder to find in this environment, but if your only avenue is to play all these new issues that are pricing at 4% or 5%, I think it will be a struggle to generate good relative performance going forward. Because we've closed, we can be much more selective on that part of the market than many of our competitors.
Stipp: Mark Vaselkiv, one of Morningstar analysts' favorite managers in the high-yield space. Thanks for calling in today and giving us your insights on that market and your outlook for the future.
Vaselkiv: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.