Getting the most out of high yield

In an environment starved for yield, financial advisers have turned to fixed-income markets to help meet the income needs of their clients.

With high-yield bonds generating strong investment performance over the past three years, it is no surprise that they have become a core portfolio holding for many.

Undoubtedly, advisers and their clients have been pleased with the steady income stream they have received from their high-yield allocation. However, allocations may be improved by considering more-creative ways to gain exposure to this asset class.

HIGH YIELD’S HIGH RETURNS

Since the 2008 financial crisis, high yield has returned an annualized 22.3%, making it arguably the best-performing asset class. Between Dec. 31, 2008, and May 31, 2012, the bonds outperformed U.S. equities by more than 8 percentage points a year, global equities by almost 17 and core bonds by more than 15.

Not surprisingly, the money has followed. Net flows into high-yield-bond funds in the past three and a half years have exceeded those for the prior 20 years combined, according to Strategic Insight's Simfund database.

Just as non-U.S. stocks and emerging-markets equities have gained a permanent place in most diversified portfolios, high yield has cemented its role as a strategic allocation. As a result, a number of more nuanced strategies have surfaced — everything from illiquid approaches, such as distressed-debt funds and strategies with varying credit qualities and durations, to exchange-traded funds.

In fact, 41 funds have been launched since 2009, versus 39 in the previous six years.

Despite high yield's growing popularity, two key variables often go overlooked: credit quality and duration. Tailoring these attributes to a client's risk profile can produce better outcomes.

For example, for clients worried about taking on too much risk, advisers can choose managers that emphasize higher credit quality in the high-yield universe. Conversely, if liquidity is less of an issue, investors more concerned about returns may wish to add a distressed or lower-credit-quality fund to their high-yield portfolios.

Since 2009, we also have seen the launch of several funds focused on specific credit quality in the high-yield category.

Duration management, a more recent development, has become another tool for advisers to control volatility within their high-yield allocations. Fourteen duration-focused funds have been launched since 2009.

Unlike investment-grade fixed income, high-yield securities tend to be less sensitive to rising rates because favorable economic conditions typically outweigh the ill effects of higher rates.

Still, duration can be an effective way to manage volatility. In the past year, many short-term funds have come to market that allow an adviser to adjust duration in a changing yield curve environment.

How investors access high yield is also important, and the recent explosion of ETFs in this asset class has sparked the active-versus-passive debate. Few high-yield ETFs existed before 2007, but 13 have been launched since the financial crisis. Further, nearly two-thirds of the high-yield funds started in the past five months have been ETFs.

With the growing popularity of high-yield ETFs, investors should consider whether there are distinct differences between ETFs in the high-yield universe and those in other markets. Although they may be heavy users of passive strategies in more-efficient markets such as U.S. large-cap equities, advisers must recognize that high yield brings other considerations into play, including varying levels of liquidity and trading structure.

High-yield ETFs have demonstrated significantly higher tracking error than investors are accustomed to in equity index ETFs. The wider bid-ask spread in the high-yield market presents a continuing challenge to ETF sponsors — as the cost is passed on to investors in the form of lost performance — versus the indexes that the funds target.

CREATIVE PORTFOLIO DESIGN

Given that high-yield bonds have gone from an esoteric asset class to a core allocation, advisers should dig a little deeper regarding their design. For example, a client looking to take on more high-yield exposure but without an appetite for greater volatility may seek to engage a core/satellite approach, such as a broad high-yield mandate combined with a higher-quality short-duration manager.

In essence, considering clients' level of comfort with the risks associated with high-yield bonds and how market conditions influence client behavior will go a long way toward shoring up portfolios.

With increasingly sophisticated and flexible options, advisers should re-examine their high-yield allocation to better complement their clients' overall portfolios.

Eric Scholl and Tom Saake are managing directors and portfolio managers at Caywood-Scholl Capital Management, a company of Allianz Global Investors. The firm manages the Allianz RCM Short Duration High Income Fund.