High-Yield Bond Q&A

Kevin Lorenz, Lead Portfolio Manager of TIAA-CREF's High-Yield Fund

November 21, 2012

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People in or near retirement often own a large percentage of bonds in order to generate stable, predictable income. Typically, this fixed-income portfolio is a mixture of U.S. Treasuries, municipal bonds and high-quality corporate debt. But with interest rates at historic lows, investors are looking to other fixed-income investments — particularly high-yield bonds — for better yields.

The attraction of high-yield bonds is clear: They offer the potential for returns comparable to that of equities with historically lower volatility. Kevin Lorenz, the lead portfolio manager of TIAA-CREF's High-Yield Fund, shared his thoughts on current market conditions and why high-yield, in the right dose, may be an attractive investment.

Is now a good time to invest in high-yield bonds? Why?

Yes, we believe so. In considering the valuations of high-yield bonds, there are three useful metrics: price, yield, and spread. Some investors have recently raised concerns that bond prices increased during the third quarter, driving down yields: As of Sept. 30, the yield for the High-Yield Master Index was 5.68% — a record low. With prices having appreciated above par, investors can’t expect prices to continue appreciating, but should focus on the incremental income that high-yield continues to offer.

Despite the high prices and low historical yields, we believe this is a good time to invest in high yield due to the favorable spread that the asset class offers — that is, the difference between the yield on a high-yield instrument and the yield on the 10-year U.S. Treasury security, which is typically used for comparison. On Sept. 30, the spread on the benchmark high-yield index was 483 basis points — exactly equal to the 10-year median and just inside the 10-year average of 508 basis points. Compare that, for instance, to 2007, when the spread was as tight as 208 basis points.

What are the advantages to owning high-yield bonds?

Long-term returns for high-yield bonds have historically been better than investment-grade corporate bonds and generally similar to stocks but with less volatility (see Exhibit 1). This makes high-yield bonds an attractive "middle ground" for investors looking for a mix of risk/reward options plus attractive yields.

Exhibit 1

Performance data as of Sept. 30, 2012

High-yield bonds have outperformed U.S. stocks over the last 10 years

1 year
returns
3 year
returns
5 year
returns
10 year
returns
BofAML U.S. High-Yield Master II Constrained Index18.8612.549.2410.73
BofAML BB/B Cash Pay Issuer Constrained Index17.6911.898.389.59
Russell 3000® Index30.2013.261.308.49

High-yield bonds have proven to be less volatile than stocks over the last 10 years

1 year
standard
deviation
3 year
standard
deviation
5 year
standard
deviation
10 year
standard
deviation
BofAML U.S. High-Yield Master II Constrained Index7.237.2413.9910.58
BofAML BB/B Cash Pay Issuer Constrained Index6.406.3212.169.25
Russell 3000® Index14.4216.2719.8815.74

Source: Morningstar Direct

Past performance is no guarantee of future returns.

The Russell 3000® Index measures the performance of the stocks of the 3,000 largest publicly traded U.S. companies, based on market capitalization. The index measures the performance of about 98% of the total market capitalization of the publicly traded U.S. equity market.

The Bank of America Merrill Lynch BB/B Cash Pay Issuer Constrained Index measures the performance of securities that pay interest in cash and have a credit rating of BB or B. The Bank of America Merrill Lynch uses a composite of Fitch Ratings, Moody’s and Standard and Poor’s credit ratings in selecting bonds for this index. These ratings measure the risk that the bond issuer will fail to pay interest or to repay principal in full.

The Bank of America Merrill Lynch High-Yield Bond Master II Index is an unmanaged index that tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. This unmanaged index does not reflect fees and expenses and is not available for direct investment.

Viewing high yield as a middle ground helps to explain the strong investor flows into high yield this year, coming from both fixed-income investors — who might want a little more return — and equity investors — who might want to take a little risk off the table.

However, investors should be cautious of funds that have trumped the benchmark this year by a wide margin, since the highest-performing funds are those that have taken the most risk. By contrast, the goal of TIAA-CREF's high-yield fund is to participate in the upside of the high-yield market while protecting investors against the downside. As of the fourth quarter of 2012, we are overweight in the higher-quality BB-rated portion of the market and underweight in the lowest-quality tier of the market.

What about risks, such as defaults?

It's certainly true that one of the biggest risks associated with owning high-yield bonds is default risk among issuers. The U.S. trailing 12-month default rate peaked in 2009 at 14.6%, but it fell very quickly over the following year and has generally been improving. For the last couple of years, defaults have been bouncing around at trough levels of 2% to 3.5%. Moody's projects that defaults will decrease to 3% over the next year — relatively benign given the historical average of 4.5%–5%. This bodes well for high-yield bonds and is yet another reason that now is a good time to own them.

U.S. high-yield bond volume is increasing at a record pace — $250 billion in new issues through the first nine months of 2012. Is that a red flag that weaker issuers are entering the market and defaults could rise more than expected?

No — just the opposite. The issuance is largely related to refinancing at today's historically low rates, and therefore it's actually strengthening companies' positions. Many companies are pushing out their debt maturities further, which reduces the risk of default.

Even if defaults did start to rise, the resulting price volatility creates opportunities for investors. We continuously evaluate bonds in the marketplace that provide good value. In this regard, our emphasis on higher-quality BB and B credits helps us manage the risk of default.

How does the Fed's position on interest rates affect the high-yield market?

Historically, high-yield bonds are less correlated to interest-rate changes than other types of bonds. While interest-rate levels remain low — which remains a stated objective of Federal Reserve policy through 2015 — high-yield bonds are likely to offer attractive relative yields compared to other fixed-income securities. Currently, for example, there is a wide spread — about 550 basis points (5.5%) as of Nov. 12 — between rates on Treasuries and rates on high-yield bonds. We believe that high-yield bonds remain attractive versus Treasuries in the current interest-rate environment, and the spreads can provide a cushion against rising interest rates when that occurs.

What else influences high-yield performance?

High-yield bonds, like any other financial asset, are subject to the whims of the marketplace. But it is helpful to remember that high-yield bonds are more closely correlated to stocks (specifically, small-cap U.S. stocks) than to certain types of bonds. A robust economy that increases corporate profits means that companies are better able to repay their debts, which benefits both equities and fixed-income securities. Although high-yield returns are volatile over shorter time periods due to price volatility, performance is driven over longer time periods by the income return that high yield generates.

What is the investment philosophy of TIAA-CREF's High-Yield Fund?

We seek to achieve attractive risk-adjusted returns over the long term. We like to say that while the Fund's asset class puts it in the vernacular of the "junk bond fund" category, we're not buying junk. We primarily invest in established companies with a history of solid cash flows and experienced management teams. The Fund is a diversified portfolio comprised primarily of higher-rated, high-yield corporate bonds and term loans. The Fund's investment philosophy is based on four key tenets: a rigorous credit selection process in which inherent risks are assessed; a disciplined approach to credit exposure, with the belief that the anticipated volatility of an issuer's cash flow should be inversely correlated to the size of the Fund's exposure to that issuer; a focus on long-term return and cash-generation potential, rather than periodic price movements; and a credit-driven sell discipline.

What sectors do you believe offer the most opportunity, and which do you tend to avoid?

We search for companies that consistently generate free cash flow and are properly capitalized for the volatility inherent in their respective industries. As a result, the portfolio is diversified across many sectors of the economy. We favor several companies in the media services sector, including Lamar Advertising and Nielsen, which we view as competitively well-positioned companies in stable businesses.

By contrast, industries that are inherently volatile, in which companies cannot control the factors contributing to their cash flow, are fundamentally unattractive to us. For instance, we tend to avoid the electronics sector, largely composed of semiconductor manufacturers, and rural landline telecommunications companies, whose businesses are in a long-term decline.

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