Vontobel Asset Management - Investors’ Insight

Investors’ Insight Vontobel Asset Management

Higher yields with a manageable risk

Contents

Summary 3 1. Future challenges for bond investors

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1.1 Interest rates set to remain low 1.2 Public debt: negative trend in industrialised nations 1.3 Corporate deleveraging 2. Options available to bond investors

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2.1 Alternatives within the bond segment 2.2 So what makes high-yield bonds attractive as a substitute for equities?

3. Why invest in high-yield bonds?

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3.1 Large market, broad spectrum 3.2 High-yield corporates with increasing refinancing requirement 3.3 A ttractive yields and low volatility compared with equities 3.4 Default rates still modest 3.5 Diversification boosts returns 3.6 Risks associated with high-yield bonds Conclusion

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Annex – Glossary

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Summary

According to the old stock market adage “Stocks help you eat well, but bonds let you sleep well”, government bonds are tantamount to a safe investment. But nothing seems further away from the truth given the ongoing turmoil in the European Monetary Union (EMU). This raises the question of what euro investors should do with the ­supposedly safe part of their portfolio.

Figure 1.1: Overview of different rating levels at bonds Ratings Moody’s Longterm

Longterm

Shortterm

Aaa

AAA

A-1+

Prime bonds

Aa1

AA+ A-1

High-grade bonds, risk only marginally greater than AAA/Aaa paper

A-2

Upper-medium grade, strong capacity to make scheduled principal and ­interest payments

A-3

Lower-medium grade, issuer still has adequate capacity to make scheduled principal and interest payments

returns and a more evenly balanced

Investment Grade

Aa2

“Nowadays any investor seeking higher

Shortterm

Prime-1

Aa3

AA-

A1 A2

AA

A+ Prime-2

A3

A A-

Baa1

BBB+

­portfolio has no option but to consider

Baa2

high-yield bonds.”

Ba1

BB+

Ba2

BB

Ba3

BB-

B1

B+

What are the key features of these investments? Highyield bonds are issued by companies with a relatively low credit rating In concrete terms this means that the credit rating of such companies is “below investment grade”, which is equivalent to “Baa3” for the credit rating agency Moody’s or “BBB-” for Standard & Poor’s (Figure 1.1).

The yield produced by this type of corporate bond for the investor is generally higher than that provided by a ­government bond with the same maturity. This extra yield is known as the spread or risk premium. This premium makes up for the extra risks the investor is exposed to when buying a riskier corporate bond.

Prime-3

Speculative Grade

Baa3

BBB-

B2 B3

BBB

B

B-

Caa1

CCC+

Caa2

CCC

Caa3

CCC-

Ca

CC

C

Contains speculative ­e lements, uncertain ­c apacity to meet financial commitments Very low ability to meet ­fi nancial commitments

B Not Prime

C

Low quality bonds, issuer may already have defaulted on a payment Junk quality bonds, ­extremely speculative

C Default

Fixed-income bonds typically form the lion’s share of portfolios held by both institutional and private investors.

But nowadays any investor seeking higher returns and a more evenly balanced portfolio has no option but to consider high-yield bonds.

Interpretation

S & P

D Not Prime

D

Issuer in default

Source: Moody’s, S & P

debt has been reduced. The risk of default is therefore limited as well. Despite the adverse market conditions since 2008, high-yield bonds have subsequently become a much more attractive asset class for investors.

It should be noted that some top companies, like the strongest economies, enjoy the highest possible triple-A credit rating, but they tend to be few and far between. Current examples include Microsoft, Exxon and Johnson & Johnson.

Compared with the situation back in 2008, the balance sheets of many corporations look very healthy today.

Their financial situation has improved and their level of Christophe Bernard, Chief Strategist Vontobel Group

Oliver Russbuelt, Senior Investment Strategist

June 2012 3

1. Future challenges for bond investors

Investor confidence has been badly shaken since financial turmoil and the debt crisis first broke back in 2008. The uncertainty has cast a deep shadow not only across equity markets, but bond markets as well. The traditional benefits of government bonds – risk-free investments guaranteeing regular and lucrative interest payments – either no longer exist, or only apply to a limited extent.

1.1 Interest rates set to remain low In the past investors have usually done well by purchas­ing government bonds and “leaving them in the bottom drawer”. But this approach is becoming increasingly ineffective, due to the historically low level of nominal yields on government bonds (Figure 1.2). Yields on sovereign bonds have been in permanent decline since the 1980s. By way of illustration: Swiss 10-year government bonds have yielded less than 1% since the fourth quarter of 2011, to give just one example. This compares with a yield of 3.5 % in mid-2008.

Figure 1.2: Government bond yields in decline 12 10 8 6 4 2 0 1960

1970

1980

German 10Y Govt. Bond Yield

1990

2000

2010

Swiss 10Y Govt. Bond Yield

Source: Thomson Datastream

German Bunds denominated in euros currently even offer negative yields in real terms (adjusted for inflation), which means that investors’ purchasing power is actually diminishing. There is no sign of any improvement, as the European Central Bank is likely to maintain its policy of low interest rates for quite a while yet in the face of the smouldering bank crisis, anaemic economic data, rising unemployment and soaring government debt.

It is very unlikely that yields on (European) government bonds will quickly rebound over the coming decades to the sort of level they stood at 10, 20 or even 30 years ago – despite the fact that interest rates have probably bottomed out already.

The same is true of the USA. Here too, key interest rates stand at historical lows. The Chairman of the US Fed, Ben Bernanke, cautioned in February 2012 that he would be prepared to hold down interest rates until well into 2014 if necessary.

1.2 Public debt: negative trend in industrialised nations But it is not just low interest rates – especially in the euro zone and the US dollar region – that tend to make investments in sovereign bonds unattractive. Another ­argument against purchasing government bonds is the declining quality of issuers of sovereign debt. As the ­financial and debt crisis has deepened, the credit ratings of most euro zone countries have been downgraded.

The question facing bond investors is therefore how – and where – they should invest the part of their port­fo­lio which they had previously assumed to be secure.

The situation is made worse by the fact that the debt mountains of euro zone countries will continue to soar in the years ahead due to unfavourable demographic trends (Figure 1.3). The keyword here is implicit state debt.

This refers to the government’s future payment obliga­tions such as future welfare benefits and pensions, as well as public health and care for the elderly.

Adding these future implicit liabilities on to the existing (explicit) deficit makes it clear that the current level of public debt looks quite modest compared with what can be expected in future.

Figure 1.3: Government debt as a percentage of GDP in industrialised countries 120 110 100 90 80 70 60 1991

1994

1997

2000

Source: Thomson Datastream

4

2003

2006

2009

2012

Unless countermeasures are taken, the demographic burden will force up euro zone debt from the current average of 80 % of gross domestic product (GDP) to more than 430 % (!) by 2060. This last figure includes implicit state debt. Although the expected increase in S­ witzerland will be far lower, from around 40 % at present to roughly 120 % of GDP by 2050, the final level will still be very high.

1.3 Corporate deleveraging In contrast to individual states, the financial situation of most companies has improved significantly since the ­technology bubble burst in 2001. The comparison of US government debt as a percentage of GDP and corpo­rate debt as a percentage of US GDP shows that America’s (non-financial) corporations have made great strides in strengthening their balance sheets over the past 11 years (Figure 1.4).

Figure 1.4: Company balance sheets: Quality continuously improving 120

Figure 1.5: : US corporate high-yield spread and default rates in % 25% 20% 15% 10% 5%

100

0% 90

90 80

92

94

96

98

00

02

04

06

08

10

12

US corporate high-yield spread

Default rate baseline forecast

Default rate US speculative

Default rate optimistic forecast Default rate pessimistic forecast

70

Source: Thomson Datastream, Moody’s

60 50 2000

Issuers of high-yield bonds have also been fairly active.

Their main focus in the years following the financial crisis of 2008/2009 has been to reduce their debt levels, extend the terms of their liabilities and build up cash ­reserves. Today the balance sheets of these debtors are healthier than they have been for most of the past 15 years, especially as far as the relationship between debt and profit is concerned. The default rate for highyield bonds is therefore likely to remain very modest ­(Figure 1.5).

2002

2004

2006

2008

2010

US government dept to GDP ratio as a % US non-financial corporate dept to GDP ratio as a %

Source: Datastream

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2. Options available to bond investors

Faced with these challenges, investors can consider alternative bond segments or equities. From both perspectives high-yield bonds are attractive.

2.1 Alternatives within the bond segment There are basically two ways for investors to gain exposure to bonds: firstly, they can diversify geographically by buying bonds from emerging-market countries. S­ econ­d­­­ly, investors can also boost potential returns by ­investing in debt paper with lower credit ratings, such as high-yield bonds. In this study we will concentrate on this second ­option. We already published a study back in March 2011 on emerging market bonds, entitled “Opportunities ­created by the global power shift: in­vesting in the next decade”.

2.2 So what makes high-yield bonds attractive as a substitute for equities?

With equity investments, the attraction for investors is the prospect of sharing in future profits. Nevertheless, cor­ porate profit margins are currently very high, and this presents a problem: Since margins have a tendency to revert to the mean, they are likely to come under pressure in the short to mid-term, which will in turn have a negative impact on share prices. Other factors likely to unsettle equity markets include weaker-than-average economic growth and the growing debt mountains of western industrialised nations. The need to make savings in many Western countries will inevitably lead to higher taxes in the mid-term, which will have a negative impact on companies and ultimately also on their shareholders as providers of risk capital.

In such a climate, we expect equity markets to continue their volatile sideways trend, as they have done since 2000. At the same time the individual cycles are likely to be rather short. Timing will therefore be critical when ­investing in equities.­ High-yield bonds are also exposed to these short cycles, although their value tends to fluctuate much less than share prices. High-yield bonds have another important advantage: a (lucrative) coupon.

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3. Why invest in high-yield bonds?

Figure 3.2: Europe’s banks need to trim their balance sheets 4.0

0.4

3.5 3.0 Trillion US dollars

3.1 Large market, broad spectrum The corporate bond market offers a broad spectrum of issuers, sectors and rating categories. The USA continues to have the biggest selection of high-yield bonds. According to the US rating agency Moody’s, the performance of Europe’s high-yield bond market was significantly different in the first and second half of 2011. In the first six months of 2011, investors had a much bigger risk appetite for high-yield bonds, with frantic issuance activity reaching a total volume of 70 billion US dollars, even beating the prior record of 65 billion US dollars worth of new ­issues set in 2010. If the European debt crisis drags on, however, Moody’s reckons that the volume of issues in the European high-yield segment will fall short of more ­recent records.

0.9

0.2

2.5

0.1

2.0

0.4

0.4

1.5 1.0

1.7

2.5

2.0

0.5 0.0

Reform scenario

No policy change

Negative scenario

Sales of equities and reduction of interbank loans Reduction in borrowing, rest of the world Reduction in borrowing, euro zone

Source: IWF, NZZ

3.2 High-yield corporates with increasing refinancing requirement The market for high-yield bonds should continue to grow: Companies will increasingly look for other sources of ­financing, because banks in both the USA and Europe are becoming more reluctant to lend money (Figure 3.1).

In the Global Financial Stability Report published by the International Monetary Fund in April 2012, the IMF emphasises that European banks must significantly trim their balance sheets by the end of 2013 (Figure 3.2). For their part, European financial institutions have announced that they intend to reduce their assets by some 2 trillion US dollars in the mid-term. And if banks lend less money in future, institutional and private investors will step in to fill the gap.

3.3 Attractive yields and low volatility compared with equities There is a common view that equities should be favoured over bond investments. For the past decade at least, that’s certainly not true. During this period US high-yield bonds performed much better than US equities – and with much less volatility. We therefore believe there is a strong possibility that the positive price trend of highyield bonds will continue in the years ahead and will allow investors to enjoy significantly higher returns.

3.4 Default rates still modest As far as default rates are concerned, the most important thing for investors is to screen issuers of high-yield bonds very thoroughly. Bank Vontobel reckons that the market is currently pricing in a default rate of 8 – 9 % for European companies – a figure that seems far too high. At the end of January 2012 the default rate stood virtually at a record

Figure 3.1: Companies increasingly financing themselves through bonds as the proportion of bank loans declines 150

80% 70%

Trillion US dollars

120

60%

90

89

83 62

60

63

60

46

30

36

2011 Bonds

Bank

2012 Total

45

50% 40% 30% 20%

25

23

16

0

81

10% 2013

2014

0%

Bank quota in %

Source: Moody’s

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low of 2.2 %. The historical average for default rates is between 3 % and 4 %. Even if there is a slide back into recession, we do not expect default rates to climb above 6 % in the next 12 to 18 months.

3.5 Diversification boosts returns Because of their generous returns, high-yield bonds act as a hedge against inflation and are an effective instrument for diversification. Research has shown that adding high-yield instruments to a bond portfolio can not only reduce risk, but boost returns.

At the same time it would be a mistake to cast highyield and government bonds in the same mould. In a wellbalanced portfolio, the role of high-yield bonds is to ­enhance returns. The purpose of sovereign bonds is to act as a cushion for risk.

«High-yield corporate bonds are an attractive addition to portfolios in our view.»

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3.6 Risks associated with high-yield bonds The extra yield provided by high-yield bonds is mainly compensation for the credit risk: the possibility of the ­issuer defaulting. Apart from compensation for the general systemic risks, the spreads can also reflect risks asso­ ciated with liquidity, future events and (if the bond can be repaid before the maturity date) early redemption.

Economic performance can also be problematic for in­ vestors in high-yield bonds. A deep recession and an escalation of the European debt crisis could trigger phases of increased volatility in high-yield bonds. Political uncertainty and social unrest could also depress demand for this type of debt paper.

Conclusion High-yield corporate bonds are an attractive addition to portfolios in our view, even though they can be riskier than government bonds. By investing in these securities, it is possible in the long run to achieve superior returns to those provided by investment-grade corporate bonds.

Sometimes it is even possible to achieve yields that are similar to equities, but without the same level of risk and with much lower volatility.

Annex – Glossary

Implicit state debts refer to the government’s future legal payment obligations, such as welfare or pension benefits, or public health and care for the elderly.

The default risk is the risk of a company that has issued bonds falling behind with payments or going bankrupt.

Long-term debt paper classed as investment grade by ­rating agencies is considered to be the highest quality.

With the US rating agency Moody’s, for example, the ­ratings Aaa, Aa, A and Baa qualify as investment grade.

Credit ratings of Ba or lower are classed as “below ­investment grade”, i.e. more speculative.

There are essentially two types of high-yield bonds.

On the one hand, corporate bonds issued by companies with poor credit ratings (“below investment grade”), and on the other, emerging-market bonds. Because of the higher risk (of default), issuers of high-yield bonds pay a higher coupon, or interest rate.

Spread or risk premium: premium to compensate investors for the risks associated with the purchase of riskier corporate bonds.

Volatility: fluctuations in share prices and interest rates on stock markets.

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06/12 EN

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