AllianceBernstein explains the rationale behind its latest products focused on emerging markets and high yield corporate bonds.
“Natural credit investors say they want to increase their yield and the beta of the credit market, but are unsure of the best way to gain access to the opportunity out there.”
The fund yields about 5%. Cunningham says valuations in credit and high yield markets are “massively attractive – not the levels we saw in 2008, but still towards historically attractive levels”.
However, since 2007 high yield bond investors suffered 15% average annual volatility, according to the Barclays Capital Global High Yield Index from January 2007 to December 2011.
To address this problem, Rudolph-Shabinsky’s product concentrates on B and BB-rated paper which, on average, has expected or actual duration inside four years.
High yield bonds (according to the Barclays Capital US High Yield 2% Issuer Constrained Index) generally made 8.25% a year, on 9.93% volatility from 1993 to June 2011.
By contrast, high yield paper with a tenor of three years or less made 8.55%, on 8.42% volatility.
High yield with hedging strategies – the same Barclays index where 15% of its yield is spent on 5% out-of-the-money S&P 500 puts – returned 7.88% a year, on 9.23% volatility. This is about 30% less than the unscreened high yield universe.
The effectiveness of a high-yield-with-hedges strategy across the cycle can be seen in the charts overleaf. Rudolph-Shabinsky explains: “We look at the high quality portion of the high yield market, which offers good risk-adjusted returns.
“In the short run, we want to capture 75% of the upside of short-term movements, but over time having fewer and lower drawdowns means you end up with a return very similar to that of the high yield market.
“We’re trying to identify where you are being paid more or less to take risk. The only environment where you want to stretch for yield is when you’re coming out of a recent crisis – the kind of environment we were in at the beginning of 2009. There will be certain periods when being more aggressive does better.”
Rudolph-Shabinsky will also use hedges to reduce risk further, limiting fund drawdowns to about 50% of the magnitude of any hitting the high yield market. The hedges may involve protection on individual issuers, bond indices or interest-rate options.
There are various other ways Rudolph-Shabinsky and his team can manage portfolio risks and add value. One method is diversification – by taking about 200 positions.
Spotting mispricings caused by forced selling is another, and Rudolph-Shabinsky highlights here a diversified exposure to companies that have fallen from high grade to high yield – so-called ‘fallen angels’. These subsequently outperform the high yield universe on average by 400bps a year, he notes.
Yet another method is to use ‘synthetic bonds’, created using credit default swaps (CDS) and government bonds. About 25% to 30% of the portfolio will hold these. Rudolph-Shabinsky says one advantage is that both CDS and debt markets are liquid, in contrast to some physical bonds.