The GCC has a bustling community of sovereign wealth funds and other institutional investors who have a wide selection of fixed income strategies available to choose from. These options include high yield (HY) strategies, which invest in bonds with a lower credit rating than investment-grade corporate bonds, treasury bonds and municipal bonds. Offering a higher yield than more commonplace investment grade instruments, issuers may include leveraged buy-outs, capital-intensive firms with high debt ratios and a broad pool of issuers, either domiciled or operating in developed and emerging markets.
As investors with a strong preference for their favoured dollar-denominated assets, the majority of GCC investors engaging in high yield strategies have a long-established pattern of benchmarking against the Barclays US High Yield Index, often against the narrower BB/B index that excludes riskier CCC-rated bonds. These indices cover only the dollar-denominated, high yield, fixed-rate corporate bond universe. Instruments are classified as high yield if they carry the middle ratings of Moody's, Fitch and Standard & Poor’s, which are Ba1/BB+/BB+ or below.
Bonds from issuers in emerging markets, bonds denominated in currencies other than the dollar, and any CCC-rated credits, all fall outside of the bounds of the Barclays US High Yield BB/B index. Following the well-trodden path of this index has become such an established practice for GCC investors that they tend to overlook other, potentially better-yielding opportunities.
Exploring alternative avenues
Research carried out by the portfolio management team at Fisch Asset Management has found that GCC institutions are missing out on the upside potential that exists in a more greatly diversified high yield strategy. Through expansion of the selected universe investors can realise superior returns, through three potential avenues. The differentiating risk/return aspects expand each time additional currencies, rating segments and regional allocations are added.
The ICE BofAML BB-B Global High Yield Index incorporates emerging markets but excludes CCC-rated bonds, with underlying securities denominated in additional hard currencies to the dollar (but with returns 100 per cent hedged into the dollar). The ICE BofAML Developed Market Global High Yield Index excludes emerging markets and CCC bonds, but does cover hard currency high yield bonds outside of USD (though they too are also dollar-hedged).
The most wide-ranging approach is reflected by the ICE BofAML Global High Yield Index. It holds other hard currency high yield bonds (also fully dollar-hedged), includes CCC-rated bonds and high yield bonds issued by emerging market corporates. A strategy benchmarked against this index would incorporate a high level of diversification with a higher return potential.
Risk and return analysis
The risk and return analysis of each high yield index revealed a series of interesting results. Index investments including additional currencies, emerging markets and CCCs performed best over the period from 2004 to the end of 2017, with riskier investments generating higher returns. This index performed best over periods of stronger global economic growth, with the highest level of underperformance during periods of global recession, such as from 2007 to 2008.
Including emerging market instruments, which offers an additional layer of diversification, did not typically deliver greater returns nor did it increase risk. The addition of CCC-rated bonds increased returns, offering investors additional risk premiums to benefit from, while also amplifying risk. Most importantly, the inclusion of non-dollar hard currency bonds significantly improved the return/risk trade-off, and this meant that the ICE BofAML Developed Market Global High Yield Index benchmark (whose only differentiating characteristic is the inclusion of non-US dollar securities) achieved both higher return and lower risk than the Barclays BB-B US High Yield. Including other currencies also raises the regional weighting towards Europe, balancing to some degree the substantial inclination the latter index has to the US.
Crucially, the Barclays BB-B US High Yield Index delivers the least risk exposure but also the most muted performance. By contrast, the ICE BofAML Global High Yield Index was found only to underperform the ICE BofAML’s Developed Market Global High Yield Index and BB-B Global High Yield Index, and Barclays BB-B US High Yield during a period of most severe crisis. With smaller dips in macroeconomic performance, the ICE BofAML Global High Yield Index was left relatively unaffected.
Overall, the ICE BofAML Global High Yield Index presented the best performance of the four benchmarks analysed. Despite slightly higher volatility and larger losses during major crises, it recovered most quickly, rebounding 60.7 per cent in 2009 and more than offsetting the 27 per cent loss in 2008, and outperformed the other indices over the long term.
The outcome of our research reveals that a broader and diversified global high yield strategy benchmarked against the ICE BofAML Global High Yield Index provides significant added value. Ultimately, this strategy has given investors higher returns, but with a similar level of risk as compared to the Barclays BB-B US High Yield Index.
The critical driver is currency diversification, with a clear benefit derived from investment in instruments issued in additional hard currencies, but hedged into the dollar. Such a strategy allows for a broadening of the opportunity set available to the high yield investor, resulting in higher returns with slightly lower portfolio volatility, thereby effectively delivering a free lunch. Now is the time for institutional investors in the GCC to look beyond US-focused high yield strategies and realise the potential of exploring a more diverse universe.
Philipp Good is the chief executive and head of portfolio management at Fisch Asset Management, a member of The Gulf Bond and Sukuk Association