Though it has its hurdles, the high-yield bond market can be an effective asset allocation tool in the right dose for long-term investors, says T. Rowe Price's Mark Vaselkiv.
Sumit Desai: Hi, I'm Sumit Desai, senior analyst with Morningstar's fixed-income management research team. Joining me today is Mark Vaselkiv. Mark is the lead portfolio manager for the T. Rowe Price High Yield Fund, which is a Gold-rated fund under our coverage universe.
Mark, thank you for joining me today.
Mark Vaselkiv: Thank you, Sumit.
Desai: So, Mark, before we get started on kind of your outlook for high yield, I want to take a step back and kind of talk to investors about how to use a high-yield bond fund within a diversified portfolio. Historically, people look at bonds as kind of their safety net for volatility in equity markets, but high yield tends to sometimes kind of behave like the equity markets do. So, given all that, what in your opinion is the best way to use a high-yield bond fund?
Vaselkiv: T. Rowe Price has historically seen high-yield bonds as an effective tool in a broader asset allocation strategy context. So, for example, in our retirement date funds. The key here is taking the long-term view on the asset class. Because of its volatile nature the opportunity to get in and out of the market can lead to very adverse outcomes. There will be years where the high-yield market dramatically outperforms, but we have seen it as a very resilient strategy. It has a tendency to bounce back. And many times when you want to own high yield, those are the scariest times in a credit cycle or an economic cycle. It would have taken tremendous courage to sell high yield in 2007 and then get back in, in 2009. 2011 was a very challenging year, but 2012, again, a bounce-back year and we're experiencing that in 2016. After difficult performance trends in '14 and '15, the market is recovering this year.
Depending on conventional wisdom and trying to use traditional tools to decide when to increase or decrease high-yield exposure is tough to do. We would recommend take the long-term approach and make sure that high yield does not represent a disproportionate share of your fixed-income allocation; 20% of your overall bond portfolio is probably a good starting point. Significantly higher than that and you're beginning to take too much risk.
Desai: So, to your point, we've seen periods of sell-offs in high-yield market before. We saw that in 2008, obviously was the biggest sell-off, but then similar kind of environment, not as bad but a little bit of sell-off in 2011 and last year, in 2015, was a pretty rough year for high yield. That being said, 2016 has been a really strong year for the asset class so far and a lot of this has been driven by the energy sector, both last year and this year so far. Oil prices were plunging last year and rebounding this year and that's driven a lot of the return for high yield. So, what are you seeing in the energy sector within high yield, and should investors continue to expect energy to drive returns for this asset class?
Vaselkiv: Past five years energy has grown to represent the largest and most substantial industry in our asset class. That's because of a significant technological change in using horizontal drilling and fracking to enhance production and get access to more oil and gas under the ground. And that's allowed the United States to increase its market share globally, but it also required a lot of capital in terms of debt financing and also equity. And many high-yield companies in the energy space borrowed very heavily and had attractive rates and that worked very well when oil was $80 to $100 a barrel but now it's plunged to $50 and for a while even lower than that, that put significant financial stress on the high-yield companies. Clearly, Saudi Arabia is taking a very aggressive approach to try and maintain their market share and frankly, put a lot of the U.S. producers out of business.
Desai: Pressuring the market to keep oil prices down.
Vaselkiv: Right. We expect that 30% to 40% of high-yield energy companies could restructure their debt. And if that's 15% of the market, times 40%, that could have a very adverse impact on the overall default rate in our market and that will particularly be more acute if oil drifts back down to about $40 a barrel. Fortunately, there has been a large wave of credit downgrades of formerly investment-grade oil and gas producers, bigger companies, more substantially capitalized, better assets and reserves, and now our opportunity set has widened so that we can own many of these fallen angels that carry BB ratings rather than the upstart high-yield companies that are more down at the lower end of the credit quality spectrum rated CCC.
Desai: Another hot topic within the high-yield market, fixed-income generally, but specifically within high yield is liquidity. Broker-dealers are no longer the natural trading partner for you if you want to sell or buy a bond. So, from your perspective, what are you seeing in the market from a liquidity point of view?
Vaselkiv: It's much harder to trade high-yield bonds today in 2016 than at any point in my career going back into 1980s. The dealer community because of regulatory changes takes much less risk. There are much fewer proprietary traders on Wall Street that are running their own books and other issues like that have made it--the market has also grown. So, it's now substantially larger than it was five or 10 years ago. Our assets have grown. So, we are trading larger blocks of bonds. At times, we will trade at $20 million or $50 million, maybe even $100 million position across our portfolios. That takes a sophisticated level of execution on the part of experienced trader at a broker-dealer.
My sense is that risk-management priorities at the major investment banks are making it much tougher to execute those trades, and it works both buying and selling bonds. Clearly, investors have focused on reducing their high-yield exposure, can I get out of my high-yield fund when times are tough, will I be able to redeem? The Third Avenue experience last year amplified that concern. But I would also say many times when we go out to purchase securities and we're hoping to add to positions, it's just tough to find the bonds buying as it is to sell them when the market is going lower.
Desai: So, the liquidity creates challenges both for selling and buying?
Vaselkiv: Absolutely. I it also leads to higher volatility. You've seen the advent of ETFs add to the drama and the volatility of the high-yield market. So, it's become a much tougher asset class than a decade ago.
Desai: So, given all that we've covered so far, how would you kind of frame your outlook for the asset class going forward? Are there areas where you're finding opportunities or are there areas outside of the energy and commodity sector where you'd kind of see any risk within the market?
Vaselkiv: The most significant reason we remain constructive on high yield for the long term is that it's evolving to increasingly a global asset class. Ten years ago 95% of our companies were based in North America. Today many good European issuers, emerging-markets corporations where we find attractive securities at higher yields and spreads than we're getting in the U.S., it provides a level of diversification. It requires more substantial commitment to resources in both trading and research. But ultimately, we believe a manager that can cast a wider net over the next five years will be quite successful. Let's face it too. We've always talked about focusing on the U.S. credit cycle or the U.S. economic cycle. Now, we can diversify some of that risk by saying, well, there are multiples cycles at work around the world, and a good manager can take advantage of that.
Desai: Great. Mark, thank you very much for joining us today.
Vaselkiv: Nice talking to you, Sumit.
