I was quoted in the ROB today in an article by Josh O'Kane. Unfortunately, much of the information I gave to Josh never found it's way into the article. I thought I would expand it here:
1. Demand for Yield is a long-lasting theme:
The 65+ cohort expands rather dramatically for as far out as StatsCan data goes...30yrs. This demand for yield has, and will continue to, come at the expense of equites where 65+ yr olds cannot take any further volatility.
2.The Capital Structure of a Corporation. How are you driving yield in your portfolio? Are you still driving it through stocks (which are at the bottom of the capital structure and who's yield is a dividend, which is simply a promise to pay)? Why not drive yield through a HY bond that is backed by a legal obligation (called an Indenture)? Your pick....the top of the capital structure with protective covenants...or the bottom with no covenants at all. As per Professor Kirzner's comments on defaults: to be sure, they are extremely low right now (~2% of the Index is in default), because HY issuers are in such great shape (Point 5 below), but they can, and at some point will, rise. When? Well, the FOMC is determined to keep interest low till 2015 and we know HY issuers are in great shape so I wouldn't look for the default rate to rise much at all over the next 3yrs. Regardless, there will be defaults, but remember, if you own the equity of the same HY issuer that defaults, you are likely to get a recover at, or pretty darn close to, zero on your equity. HY bonds typically have a recovery in default of around 40cents on the dollar, and some with excellent security packages can have par or more (100.00). As the title of the story says, having a professionally managed portfolio will ensure diversification in the unlikely event that an issuer defaults. Yellow Media is probably a good example of what happens to HY bonds and stocks during a default/restructuring...the equity will get effectively zero in the restructured company while the bonds will get a recovery of about 70cents/$...plus the accrued interest since filing it's Plan of Arrnagement with the court in Quebec. Not bad.
3. Very Strong Risk-Adjusted Returns.
A picture is worth a thousand words. This is taken over the past 5yrs ending July, 2012. Think Canadian Bank stocks are less risky than C$ HY? Think again...just look at the risk you are taking at 19% volatility for only a 4% return per year. Crazy risk. And REITs and Utilites produce a similar story. Be not afraid and always remember Point 2 above..you are in a safer part of the capital structure in HY than equities.
4.Low Correlations. C$ HY exhibits very low correlations to other asset classes (5yrs ending July 2012). What this shows is that C$ HY is a separate asset class unto itself and as per my quote in the ROB, there is ZERO correlation to interest rates. If rates go up because central banks make it so, becuase the economy is improving, then it is most likely that companies are increasing their cash flow and it is that cash flow that pays our coupon. The more cash flow the company produces, the more of a cushion we will have under us for them to pay their coupon interest. IE to say, interest coverage (Ebitda/Interest Expense) rises. A very good thing indeed.
5. HY issuers are in very good shape.
They may be levered companies, and some people may even refer to them as junk, but check out what they look like right now. In general, US HY issuers, have very high cash balances, below-average leverage, and record high interest coverage (Point 4 above). This supports the flow of funds that has, and will likely continue to, find it's way out of equity funds, and into HY funds. All companies stared over the abyss in 2007-2009 and I think they have found religion and are unlikely to commit to any strategies that will alter this current state of strength. I think this is largely part of the stubborn unemployment problem in the USA. Good luck Mr President.
6.The Buy Canada Theme.
Canada is likely to have a balanced budget in 2015...the USA?...well, without going into political views, it is likely to balance it's budget by 2045. High Rock believes that investors will be more "protected" in C$ HY, than U$ HY, especially if there is a fiscal crsis south of the border. Moody's even published a report in Sept/12 stating that a review of over a thousand HY bonds showed that C$ HY bonds had better protective covenants in their Indentures than U$ HY bonds. Our market is growing and becoming more diversified (C$ HY is arguably way more diversified than C$ Investment Grade where the bonds are all Financials, mixed in with some Utilities). Also, we are Canadian and have significant relationships here with both the sell-side dealers (for excellent trade execution on new issues and secondary) as well as issuer's management teams who we meet with often. The bottom line: we have our "ear to the track" in C$ HY and feel we have a competitive and comparative advantage operating in Canada vs the USA.
Conclusion: To be sure, there is risk associated with HY bonds...every financial asset has risk...gov't of Canada bonds have risk..it is all interest rate risk and very little credit risk...but it is risk nonetheless. But what investors need to focus on is the risk-adjusted returns...ie...how much risk are you taking for the return you are receiving: C$ HY proves near the top of the heap. And given the lack of correlation of C$ HY bonds to those other investable asset classes, it makes sense to have a weight in your portfolio to this asset class. How much weight? Well, you need to be your own liquor control board and, like every portfolio decision, it should be specific to each individual, and designed by a professional. What I can add is that Professor Kirzner at Rotman flat out says investors should limit their exposure to HY to 5%. How he came up with that number, I have no idea. What I do know is that given the historical data of how well HY performs over time, 5% will not likely affect your portfolio enough to gain all the strong positives we mention above. Work out a 60/40 split portfolio in stocks/fixed income, run some regression on the 5yr retuns and volatility. Then do the same thing stripping out 15% of the stock component and 10% of the fixed income component. And you ask, "25% in a well-diversified HY portfolio? Are you nuts?" (I don't think I am, but I am more than 25% investred in C$ HY. I see it as far-more defensive than otherwise). Well would you invest 25% in equities...the bottom of the capital structure, with far-less risk-adjusted returns (less return, more risk), maybe with a dividend (that can be cut to zero with no repercussions to the issuer), with no protective covenants through a legal document (the Indenture)??? Yes you would, but I think you should reconsider that weighting to C$ HY.
Sources: BAML, Bloomberg, High Rock Capital, StatsCan, Trading Economics, Department of Finance, Canada, US Treasury.
Timeline: 5yr return statistics are calculated ending July 31, 2012.