What Should Investors Expect From High-Yield Bonds Today?

Sumit Desai: Hi, I'm Sumit Desai--senior fixed-income analyst with Morningstar's manager research team. Joining me today is Jim Keenan, global head of credit at BlackRock. Jim is the lead portfolio manager of BlackRock High Yield Bond (BHYAX).

Jim, thank you for joining me today.

James Keenan: Thanks, Sumit.

Desai: As lead manager of the high-yield portfolio, obviously you have a lot of views on where we are within the credit cycle. Maybe you could spend a little bit of time talking about where exactly we are within the credit cycle and your expectations for the high-yield asset class going forward.

Keenan: We're definitely in the later stages of the credit cycle here. But the question is how much longer do we have and what types of assets and risks do you want to have at this point. And obviously, I think at this stage in the cycle is when you start to see a lot of the protections start to get stripped out of bonds. Covenants start to get weaker; you start to get more aggressive with regard to your management teams; and corporations start to add more risk, whether that's through M&A activity or shareholder-friendly buybacks and dividends and those types of things.

So, you really have to be disciplined on the types of risks that you're buying when you're adding leveraged credit risk or high yield or bank loans. I think you have to be disciplined, diversified, and really specific to the security level that you're buying. For the asset class as a whole, we have not viewed this as a great opportunity. The question is where we are in the cycle and the different types of risk rewards that you want to have. We're in a period of time where we're still in a low-growth environment. We're still seeing modest inflation, and the economy is still continuing to improve.

So, at this point in time, when you look at the world's fixed-income asset classes, 85% of them are still trading at less than 4%. When you look at equities, you still have high multiples right now. Nothing looks really cheap at the time when I would say volatility is coming back to the market. And so when we look at this, if the market over the next two to three years is going to be in a modest-growth environment--even though [volatility] is coming back--the high-yield asset class, we think, is looking at a 4% to 6% type of return. That's not attractive in historical terms, but it's still good in relative terms when compared with the risk of drawdown or volatility in the equities or the low carry or interest-rate risk that you might have at this point in the cycle in most fixed-income assets.

Desai: Obviously, a hot topic for all bond investors right now is the Federal Reserve and what they'll do with rates. How would you expect high yield and, specifically, your fund to perform in an environment where the Fed is raising rates?

Keenan: I think the Fed is going to obviously raise rates, and we still believe it's going to be a slow path, as they start to move away from their zero-interest-rate policy. And that's largely because of our expectations of modest growth and modest inflation increases. That is still positive from a corporate-earnings perspective, and it's still positive from a credit perspective. High yield and bank loans tend to do well in rising-rate environments that are coupled with an improving economic perspective. We think that, in the high-yield market, there is some volatility on the longer end--call it closer to 10-year high-yield bonds. But high yield still is relatively countercyclical, and so we think at a 500 [basis-point spread over Treasuries] that high yield will still do well. And again, that's mid-single digits. But relative to other fixed-income assets that might have a negative return because of a rising-rate environment, high yield still stands out as being pretty good in this part of the cycle.

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Desai: You mentioned bank loans. How should investors think about the trade-offs between bank loans and high yields? How should they approach both of those asset classes? Is there room for both within a portfolio?

Keenan: Definitely. It's interesting. Over the last 10 or 15 years--and certainly it continues to escalate more globally--high yield and bank loans have some secular tailwinds. It's an asset class that continues to grow and evolve for our investor base to own as more of a strategic asset, as opposed to a tactical asset. So, we think high yield and bank loans, relative to equities and fixed income, are now becoming more strategic assets for our clients to own.

We like bank loans at this point for a longer term. We think there might be some volatility in the short term; but in the longer term, you're getting a good-quality yield. They're floating-rate instruments, meaning that they don't have the sensitivity to the shape of the yield curve. They're floating-rate instruments, but they are senior-secured. So, you are getting a first lien on the property, plant, and equipment. And you tend to have better protections on the downside risk, which we like at this point in the cycle.

Desai: A lot of folks that we talk to are concerned about liquidity in bank loans and high yield. Can you talk about what you see from a liquidity perspective and how investors should expect those asset classes to perform?

Keenan: I would say high yield and loans have historically had less liquidity than some other asset classes. I would say in today's environment there is low liquidity, but some of that is because we have been in an environment with very low volatility. So, the cost of trading is very high relative to the low volatility, and so what I think you see today is investor bases that want to just continue to hold the asset class as opposed to trading in that volatility.

If there is a dislocation in the market or there is a disruption, there will be price volatility. Liquidity will start to come back, but there will be price volatility. And certainly risk assets, including high yield, will trade off significantly, depending on the level of risk that happens in that dislocation. And you saw this in the energy market in the third and fourth quarter of last year when you saw volatility in a commodity, in which case all high-yield energy companies started to trade off significantly on that. But then you started to see trading and liquidity come back because now you started see a lot more relative value investing at that point because of the volatility of the asset.

Desai: So, am I right to interpret that you think that there might be a bit of a floor to that? So, if there is an illiquidity event in the market, eventually that would attract buyers and close the valuation gap that the event would cause. Is that the right way to look at it?

Keenan: I wouldn't say valuation gap. What I would say is that there are a lot of risk factors that are in the market, and they are specific to companies or they are specific to overall macro environments. Where that dislocation happens, it will change the pricing of risk assets, and that will change the price volatility. And certainly, whether it's equities or credit, it will sell off because the risk of those assets will change. As those prices start to change and that volatility starts to happen, that will start to bring in other buyers because of what a given investor base is looking for. There are a lot of different people who invest in credit, and certainly if you got to an environment where certain assets become more distressed-oriented, there is a different investor base. We have fund structures that are looking to target that type of asset and those types of returns. Even on our own platform, we have a variety of different structures across our alternatives platforms and our illiquid platforms that would target those assets if they were to see dislocations.

Desai: You mentioned the energy sector. You've tended to be underweight that sector for most of this sell-off, and that has helped your fund's performance. Can you talk about not just energy but where else you are finding opportunities and where, from a sector view, you are putting money to work?

Keenan: I would say that our analyst in energy had a fantastic call on that over the course of the last couple of years. We did have a significant underweight--largely in the services and the E&P side. We started to add some of those back in some of the higher-quality names. We start to see some stability in the commodity at these prices, and obviously we've seen rig count drop dramatically in the U.S. There are some opportunities that you'll find in the energy space on a long-term horizon as you start to balance out the supply/demand from both the gas and oil.

So, we are looking at some opportunities within the energy space. There are a lot of other areas in which we're seeing opportunities from a relative value standpoint. We do think that there'll be more dispersion between certain companies or certain sectors, and M&A is starting to pick up. So, I think if you look and you're specific to certain securities or certain names, there are opportunities that you can really capitalize on. You're seeing M&A in the health-care space, in the insurance space, and more recently in the cable sector. What we're looking at is a lot of different companies where we are seeing either cyclical growth or a lot of protections built into the securities so that you can see some upside convexity.

Desai: What is the impact of all this M&A? If you expect M&A activity to increase, what is the impact on the high-yield market? What does that mean for investors in this space?

Keenan: For the large majority of investors in high yield, it's generally positive. Certainly, there are some instances in which it becomes more negative; but overall, it's generally positive. It's something that generally drives the equity multiples higher, which is good from a credit perspective. Most high-yield bonds still have covenants that protect against a change of control or M&A activities. So, when there is an M&A event, it tends to be of positive for certain securities--you can get upside potential on those. It also gives us new opportunities to look at the financing on those new entities or on that M&A deal, and it sometimes brings some new securities into the market.

Desai: The risk, then, would be that as companies use debt to purchase other companies, leverage is going to increase across the capital structure. Is it fair to say that?

Keenan: Absolutely. And you are seeing that in the investment-grade space more so than you are seeing it in the leveraged-finance space, with some of the rules and bank terms that you are allowed to provide on leverage. But that's absolutely right, and I think that's the focus that the market really has to focus on over the next three years: When you are in these later stages of the cycle, what are these companies doing? How much financial risk are they putting on their balance sheets? How much operational risk are they putting on their balance sheets? We need to work to understand that risk/reward because this is the point in time where you really have to decipher what is a good credit and what is a bad credit. But there are both going to be opportunities on the long side as well as the short side.

Desai: Jim, thank you very much for joining me today.

Keenan: Thanks, Sumit.