Annual Report & Directory Of Fixed Income Managers Canadian High Yield Hedge Investing
By: Laurence Cashin & Barry Allan
And, with the shortage of supply of these products in Canada, pension funds are looking not only at new strategies, but outside the borders of Canada.
This marks Benefits and Pensions Monitor 2nd Annual Report and Directory of Fixed Income Managers.
In this yearʼs report, Laurence Cashin and Barry Allan, of Marret Asset Management which sub-advises on Core Plus mandates for Greystone Managed Investments, examine Canadian high yield hedge investing.
Canadian corporations that need term financing and have non-investment grade credit ratings must issue U.S.-dollar denominated debt in the U.S. high yield market – with very few exceptions. Canadian high yield debt is underwritten in the U.S. because the buyers are American. More than 85 per cent of the high yield debt issued by Canadian companies is held in American institutional and mutual fund portfolios. The U.S. high yield market exceeds US$1 trillion with roughly $40 billion from Canadian issuers.
Canada is a country without a mature domestic non-investment grade corporate debt market and structural inefficiencies create opportunity for hedge strategies. For example, a portfolio holding capital structure arbitrage trades on Canadian high yield issuers can deliver excess returns with less volatility than 10-year Treasuries. A brief review of the asset class is needed before outlining alternative strategies in Canadian high yield. For simplicity, no distinction is made between leveraged loans and bonds. An introduction to the distressed debt asset class and contingent claims analysis is also needed.
The High Yield Asset Class
To be considered unique, an asset class must have a significantly different risk/return profile and a correlation with other asset classes below 0.8. Noninvestment grade debt meets this definition. For the 25-year period 1982 to 2006, the correlation with Treasuries is 0.20 and the correlation with investment grade debt is 0.50. For the period 2000 to 2006, non-investment grade debtʼs correlation with Treasuries is negative.
The creditworthiness of corporations varies and quality differences are reflected in relative bond yields and in the credit ratings issued by private agencies such as Standard and Poorʼs Ratings Services and Moodyʼs Investors Services. S&P ratings notch downward from AAA to C. As shown in Table 1, BBB- and higher is investment grade (or high grade) and BB+ and lower is non-investment grade (also known as high yield or, pejoratively, junk). Multiple issues from the same issuer can have different ratings. For example, secured notes will have a higher rating than unsecured. Related issuers within a corporate structure can also have different ratings. For example, an operating subsidiary closer to the cash flow may issue senior investment grade notes and the parent holding company may issue subordinate non-investment grade debt. It is a fair comment that there is some subjectivity in agency credit ratings, that ratings often lag the market, and that no consistent mathematical relationship between the ratings categories exists.
Table 2 disaggregates the components of total return on a simplified basis. High yield total returns have a treasury-return component. However, high yield bonds have substantial coupons and low duration and are less sensitive to interest rate moves than Treasuries.
The return of the asset class is more dependent on the credit spread – the yield differential between high yield bonds and Treasuries. The credit spread is the reward for the credit risks that are borne – the risk of credit deterioration and the risk of default. The larger part of the yield premium compensates for the expected loss from future defaults and the balance is the credit risk premium. Credit spreads also contain a liquidity premium to compensate investors for lower liquidity in the corporate bond market (corporate bonds trade less frequently than highly liquid Treasuries) and friction costs such as bid-ask spreads.
The opening credit spread is the expected excess return over 10-year Treasuries for the holding period. Any subsequent narrowing of credit spreads due to positive macroeconomic conditions adds to the return of high yield portfolios, and any widening of credit spreads due to worsening economic conditions reduces return. Balance sheet leverage makes high yield bond issuers quite sensitive to sharp changes in economic conditions. High yield credit spreads widen dramatically during recessions and narrow quickly during economic expansions.
The 10-year U.S. Treasury note is generally used to compute credit spreads because high yield bonds are issued with a 10-year maturity – albeit usually with only five years of call protection. Given that Canadianissuer high yield bonds are U.S.-dollar denominated, their credit spreads are also computed as a spread over U.S. Treasury notes. The spread of the Merrill Lynch Master II High Yield Index on March 31 was 285 basis points. Chart 1 depicts historical credit spreads.
High grade and high yield bonds can experience default if the issuer encounters financial distress. However, defaults on investment grade bonds are rare. High yield is more exposed to credit deterioration and default because high yield issuers have more financial leverage on their balance sheets and debt servicing consumes a larger portion of cash flow. The average annual issuer default rate was 3.5 per cent in the 25-year period 1982 to 2006. The trailing 12-month default rate at March 30 was 1.6 per cent.
The annual total return of the benchmark U.S. high yield index for the past quarter century ranged from 39.2 per cent in 1991 to-5.1 per cent in 2000, the worst year in history. The 25-year period had only four negative years. Table 3 gives the four best and four worst returns in the period, highlighting the attractive risk/reward profile.
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