In the short-term high yield bond market, the double and single B-rated bonds seem to offer compelling risk-adjusted returns. Tom Price, CFA, Managing Director and Senior Portfolio Manager with Wells Capital Management's Fixed Income Team, explains why in this excerpt of On the Trading DeskSM from Friday, September 7, 2012. Tom manages several funds and authored an Investment Perspective on the topic.
Before getting into the headline question, could you give us a brief update on the short-term high yield space?
The short-term high yield space has had significant interest recently, and I think the primary reason driving that is, obviously, yields are very low in the U.S. right now, and so people are looking for yields in their portfolio. But to get significantly higher yields, a lot of times that means taking on longer duration. Right now with rates so low, people are fearful of rates heading higher and longer-duration securities underperforming. So that leaves short-term high yield in the sweet spot where it offers an attractive yield but it has a short duration. Because of that we've seen numerous other products launched by fund families recently. That's generated additional interest and brought new people into the space.
And now about those BB- and B-rated bonds. Why are you thinking they're a compelling opportunity?
As we mentioned in our Investment Perspective we wrote in June, we think they offer very attractive risk-adjusted returns relative to other fixed income investments. One of the other things we think is important is the fact that if you look at the way the rating agencies rate bonds, their ratings fail to account for the maturity of the bond. They're looking at the capital structure of the individual issuer. So if you buy a senior bond that's two years to maturity or ten years to maturity, they have the same rating. Let's say they get a BB rating. We can look out two years and have much greater certainty that that company can pay us back. Looking out ten years, there are a lot of things that come into play: there's greater economic uncertainty, greater company uncertainty, just because of how different industries perform over time, a lot of cyclicality. So we think by focusing on that front end, that the two-year BB actually is underrated. We think that provides an attractive opportunity. The final thing I would mention is we look at BB and B-rated bonds, some in the space also look at CCC bonds. We think the CCC space is too volatile in the short-term high yield category, and the reason is CCC's offer significantly more downside risk if there's a mistake made in the investment. We think B and BB bonds allow us to minimize that downside.
“Risk-adjusted returns.” For novices like me, can you explain what that means and how it applies to these bonds?
The risk adjustment is adjusting for the level of risk you're taking. We could generate significantly more income for our portfolio, but to do that we would have to take significantly greater risk, and greater risk means the potential for much greater principal loss. And so the risk-adjusted returns end up being very attractive because we're able to minimize volatility. There might be a product with significantly greater yield, but go through a period like 2008 or even the third quarter of 2011, it has much greater volatility. That's why we look at investing on a risk-adjusted basis.
Tom, as always, we would welcome a parting thought for investors.
The short-term high yield market has a 1 1/2 year duration, roughly. I would caution investors that their holding period should be similar to that. If they want to add additional income, and can hold onto this product for 18 or 24 months, we think it can make a compelling part of a diversified portfolio.
Tom, we look forward to the next time we can talk here On the Trading Desk.
Thanks Peter. I appreciate the time.