Understanding risks in high-yield investing (excerpt)On the Trading DeskSM—
By Peter Nulty
As the high-yield market heats up, we pause to reflect on a healthy approach to investing in this space. Here to lend understanding in this excerpt of On the Trading DeskSM from Friday, February 15, 2013 is Tom Price, CFA. Tom is managing director and senior portfolio manager with Wells Capital Management’s Fixed-Income Team and manages several products in the high-yield space.
Tom, would you begin by describing the typical high-yield investor and what he or she might be looking for?
Number one, they’re looking for additional income in their portfolio. The income is higher because you’re taking greater credit risk. Second, I think it’s typically an investor who is able or willing to withstand a little bit of price volatility. We’re not as risky overall as an equity asset class, but we’re not as stable as you’ll see, typically, in investment grade fixed income. So, looking for a little bit of additional income but able to withstand some price volatility, that would be the typical high-yield investor.
Where does high-yield investing fall in the spectrum of risk?
Picture a line, least risky on the left. Start with money markets and move to Treasuries, investment grade bonds, high-yield bonds, and then into equities. That’s the spectrum of risk based off of historical volatility of prices from these asset classes. But I think it’s important for people to understand that those are long-term risk parameters. Right now, one of the fears for people in the Treasury market is, if the Fed moves and the economy does well, Treasuries could be very volatile. Particularly longer-duration Treasuries could have large price swings. So look at these things over the long timeframe, but realize that, within shorter windows, each one of those [asset classes] could perform differently.
No asset class comes without risk. What’s top of mind for high-yield investors?
Companies have a greater probability of defaulting as you move down the credit spectrum. When a company defaults, ultimately files for bankruptcy, not only do you not earn income, but you’re unlikely to get all of your principal back. Sometimes you may get ten cents on the dollar back, other times you could get all of it back.
In previous interviews, Tom, you’ve talked about reaching for yield. In this environment are investors reaching and what’s the danger for them?
I definitely think some investors are reaching for yield. That, to me, is defined as somebody who has never been in the high-yield space, who is now moving into the high-yield space. We’ve seen a lot of flows into high yield. The same as Treasury investors who have moved into the investment grade space, investment grade buyers have moved into the high-yield space. Why are they doing that? One, yields are just so low that people are trying to find additional ways to find income in their portfolio. But second, there’s this big fear that Treasury rates won’t remain at the levels they’re at. And if Treasuries are going to actually move a lot higher and prices are going to decline, people are trying to move into an asset class that is less correlated. Which, obviously, the high-yield market is less correlated with Treasuries. But the danger is that the market has moved south, and we’re much more correlated in the high-yield space with equities than we are with Treasuries. But if there is something that causes risk premiums or a drop in the amount of risk people are willing to take in the markets, I think you could see high yield trade off a little bit. In that situation, people who have only recently moved into the space have not earned additional income, and they’ll have greater volatility and potentially experience price decline. You don’t see that near term, but that is the risk that people are taking.
Another risk story in high yield involves investments with “dangerous covenants.” Would you explain what that is and what the risks are?
Say a company comes to market, and they have $500 million in debt. The covenant may limit them to $700 million. They can add more debt, but they can’t go to a billion. Another is called restricted payments, which limits how much money they can take out of the company, whether through a dividend or some other means that would take money, potentially, away from bond holders. “Dangerous covenants” are generally a lack of covenants. As the market gets hotter and there’s a lot more money coming in, buyers have less leverage on what covenants to enforce. And, on the margin, they can ease up the covenants a little bit as they go along. Come out of a credit crisis like we did in ’08, the initial deals had very strict covenants. [Now,] they’re getting less restricted for the issuer.
What’s a reasonable amount of time an investor should be prepared to let a high-yield investment work for them?
I think it’s important for people to have an investment horizon that’s similar to the stated duration of a product. If its duration is one and a half to one and three-quarters years, that is a realistic time horizon. Longer duration high-yield funds are [typically] four-year. [Duration] is a good rule of thumb.
We would welcome a parting though for investors.
We mentioned a lot of risk, but because every asset class performs differently and because they all have different correlations with each other, we think it’s important, at all times, for investors just to remain diversified. And realize that any one of their investments might not perform as well as another. But a diversified portfolio over time is the right way to go.
Tom, thanks for joining us here On the Trading Desk.
Thank you, Peter.
The views expressed are as of 2-20-13 and are those of Peter Nulty; Tom Price, CFA; and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.