By Samuel Lee
A version of this article was published in the May 2014 issue of Morningstar ETFInvestor. Download a complimentary copy here.
For the past year or so, I've warned ad nauseam that stretching for yield is dangerous. When your Aunt Marys and Uncle Joes are climbing onto the bandwagon, it's time to hop off. Of course, many readers still want income assets and have duly ignored my finger-wagging. Rather than preach abstinence, I've come around to the notion that it's better to teach safe, um, income investing.
Yield is like oxygen: When it's there, people behave sensibly and take its existence for granted, but as its level drops, they start getting woozy, then lose their critical faculties, and then fight to get more before passing out. We're at the stage where investors are losing their heads--maybe past it.
Yields are low. Not only are they low, but risky bond yields are too low compared with equivalent-duration Treasuries. The yield difference between a credit bond and a Treasury is called the yield spread. Because lots of bonds have embedded options that can affect their cash flows, analysts like to look at the options-adjusted spread, or OAS.
The table below tells the story. It shows various yield statistics for U.S. corporate bonds, grouped by credit quality. The Effective Yield column shows yield adjusted for options. The next column shows OAS. Percentile shows where today's spreads rank since the end of 1996; lower values indicate tighter spreads. Historical Annual Credit Loss indicates how much bonds of that credit quality have lost on average after recoveries are taken into account. Credit Premium is the OAS minus the historical annualized credit loss; it can be interpreted as the expected additional return for bearing credit risk. Expected Nominal Return is calculated by subtracting annual credit losses from effective yield.
The table indicates that the lowest- and highest-quality bonds are trading at tight spreads relative to history--spreads associated with boom times when lots of dumb decisions are made. Investors are not being compensated much for taking on credit risk. Bonds rated CCC and under, for example, have been more expensive only 9% of the time since 1996. Spreads this tight coincided with periods of irrational exuberance, like 2005-07.
There are a couple of concrete investment implications I'll explore. But before that, I want to kill a bad justification for junk bonds' thin spreads: Default rates are low and are projected to stay low; therefore, such bonds still offer attractive loss-adjusted yields.
At the peak of every business cycle, market strategists, bond investors, and the financial media all come up with reasons present and forecast conditions warrant rosy valuations. Indeed, without such consensus, credit cycles couldn't exist. Almost by definition, the consensus is bad at forecasting business cycles, because the business cycle is born out of surprises. A forecast that defaults will stay low is essentially a forecast that a recession will not occur. If you believe consensus economic forecasts, I have a bridge to sell you.
The consensus could be right--and often is in the short run--as asset prices move in self-reinforcing cycles. But rather than bet on the unwisdom of crowds, I think it's better to include a margin of safety and keep one's expected credit losses tethered to the historical experience. I'm suspicious of today's justifications for low risk premiums, as they sound like justifications at the peaks of all credit cycles.
Ignore what the smart money is saying and look at what it's doing. As a group, alternative asset managers have had nearly impeccable timing on their initial public offerings. These firms are not run by dummies. Fortress Investment Group (NYSE:FIG), Och-Ziff Capital Management Group (NYSE:OZM), and Blackstone Group (NYSE:BX) all first floated shares right before the financial crisis, and other asset managers were on the verge of doing the same. It's a sign of the times that The Carlyle Group (NASDAQ:CG), Oaktree Capital Group (NYSE:OAK), KKR & Co. (NYSE:KKR), Apollo Global Management (NYSE:APO), and, most recently, Ares Management (NYSE:ARES) have gone public over the past few years. Leon Black, head of Apollo, said last year, "We think it's a fabulous environment to be selling...We're selling everything that's not nailed down."
Valuations tell you why smart money is exiting. The expected credit premium for junk bonds is around 1%, about the same as investment-grade bonds. If you are passively allocating to junk bonds, you had better have very good reason. Most high-yield bond exchange-traded funds have several things going against them: 1) their price-indifferent rebalancing trades move bond prices against them; 2) their bonds trade at premiums because of their liquidity; 3) they are not all that cheap--you can get some very fine actively managed funds for comparable or lower expense ratios; and 4) they are passive vehicles in an inefficient, illiquid market, incurring an opportunity cost for investors who can identify superior, low-cost managers.
If you invest in actively managed junk-bond funds, they had better be really good or cheap (preferably both), because a 1% expense ratio eats up all the expected excess return from junk bonds. And if you're favoring the highest-yielding, bottom-of-the-barrel bonds, you had better be invested with an elite manager, because the sector is going to get devastated when the credit cycle turns.
That said, bonds rated CCC and under are not necessarily undesirable. Distressed bonds are even less efficient than regular junk bonds, and a savvy manager with a team of elite bankruptcy lawyers can overcome the structural deficiencies of the sector. The best such managers, alas, are hedge funds and private equity firms, who usually don't offer their services to the public at reasonable prices.
Bonds rated BBB and BB offer the best bang for the buck in terms of risk. Historically, BBB and BB rated bonds lost 0.13% and 0.70%, annualized to defaults, but today yield 1.43% and 2.42% more than equivalent-duration Treasuries, respectively. Such "crossover" bonds have historically offered anomalously high risk-adjusted returns, likely because of regulations that force institutions to restrict themselves to investment-grade bonds. Bonds upgraded to investment-grade from junk attract lots of attention from these institutions, and bonds downgraded to junk from investment-grade get dumped en masse.
This anomaly persists likely because of leverage aversion. Many high-yield bond managers can't use leverage, so they extend maturity or reduce credit quality to achieve target expected returns. (PIMCO funds are a notable exception, which likely has contributed to their excellent risk-adjusted returns.) Because investors fixate on realized yield rather than prospective total return, there is a lot of pressure to keep exposure to the lowest-quality junk bonds. Fear of tracking error also plays a role, as bonds rated CCC and under have an outsized influence on the returns of junk-bond benchmarks because of their high volatilities and high cash flows.
Today's environment suggests three courses for achieving respectable yields, from easiest to hardest: apply leverage to BBB and BB rated bonds and exploit the crossover anomaly; move beyond traditional corporate credit; and, finally, invest in such exceptional junk-bond fund managers that their skill-driven returns outweigh the sector's poor prospects.
I won't go into the last two routes. The first route, though, has a clear winner: closed-end fund BlackRock Credit Allocation Income (NYSE:BTZ). The fund is, as far as I can tell, the most efficient way an individual investor can leverage up high-quality credit and take advantage of the crossover bond anomaly.
I touted BlackRock Credit Allocation Income back in December, when it traded at an absurdly low 15% discount. At the time, our CEF analysts gave it a Morningstar Analyst Rating of Neutral but have since upgraded it to Bronze. This CEF charges an expense ratio around 1% before interest expense, 1.15% after. However, the fund's 12.5% discount means its 6.2% net asset value yield translates to a 7.1% price yield, offsetting around 0.9% of the fund's expenses. A 0.25% effective expense ratio for a high-quality 7%-yielding fund isn't a bad deal at all.
Almost half the fund's assets are in BBB rated bonds, the lowest level of what is considered investment-grade, and about a third in BB and B rated bonds. The main drawback is its duration of 5.8 years. Because the fund is mostly invested in higher-quality bonds, it won't be as resistant to changes in interest rates. If yields stay low, management may take on more risk in order to cover the distribution.
BlackRock has not historically had much luck with fixed income. The firm's fixed-income unit had a miserable 2008, prompting CEO Larry Fink to import talent by buying Rick Rieder's hedge fund R3 Capital Partners in 2009. Rieder replaced the fund's management in June 2011 with Jeffrey Cucunato, Mitchell Garfin, and Stephan Bassas, so the fund's poor past performance is not all that telling. Of course, there's no reason to believe BlackRock's fixed-income team is in the same league as PIMCO or Doubleline. Fortunately, I'm not recommending this CEF on the basis of its managers' outstanding talent. The fund, like most BlackRock CEFs, derives its merit from its relatively low cost, attractive discount, and decent stewardship. Inside ownership is negligible.
There are risks. Aside from moderate interest-rate risk, you are taking on substantial liquidity risk. Closed-end funds trade at dumb prices all the time. During panics, discounts can temporarily widen. During extreme panics, when money markets freeze up, leveraged funds are often forced into fire sales to meet margin calls, locking in capital losses. You can mitigate this risk by buying more shares of the fund yourself when the fund is deleveraging in order to restore effective gross exposure. If you're the type of investor who's liable to sell out because prices fall, closed-end funds are not for you. Nor are junk bonds, which have similar risks.
- Junk bonds, especially the lowest quality, are expensive and unlikely to reward you over the full business cycle.
- Smart money is selling. You should, too, probably.
- The easiest way to achieve a respectable yield in fixed income that I know of is to take advantage of the relative value in BBB and BB rated bonds, a pocket of credit markets that seems to be structurally underpriced.
- BlackRock Credit Allocation Income (BTZ) is the best fund I know of to exploit this idea.
- It yields 7% on market price, trades at a 12.5% discount, and carries an effective expense ratio (once you take into account the yield pickup from its discount) of 0.25%.
- The big risk isn't rising rates, but selling out of the fund in a panic.
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