Fixed Income Opportunities Highlighted By Selected High Yield Sectors

POTENTIAL TO COMBINE INCOME AND GROWTH OVERCOME GLOBAL CONCERNS

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Oct 29, 2014, 09:00 ET

PASADENA, Calif., Oct. 29, 2014 /PRNewswire/ -- Fixed-income markets remain volatile: Europe is challenged, Brazil might struggle, and China is dealing with a potential property bubble. Opportunities nonetheless remain rife for savvy investors, particularly in the high-yield markets. Western Asset believes high-yield should be a key component of any successfully diversified bond portfolio.

"We are pretty bullish on credit in general, and high-yield in particular," explained Michael Buchanan, Head of Global Credit at Western Asset. "Credit is less about the overall economic environment and more about strong corporate fundamentals. Corporations can do well in a mediocre economy, and that seems to be what's happening."

"Three factors are important right now: the overall economic environment is supportive; strong active management allows us to identify the right opportunities; and valuations are as compelling as they have been in months. This is a good time to take a fresh look at high-yield."

With the overall interest rate environment at very low levels, yields of 6 percent or more on high-yield bonds have been capturing investors' attention. This creates very attractive spreads, which should continue to hold for some time. When combined with income from coupons and higher yields, high-yield bonds offer strong income advantages over other fixed-income products.

Western Asset also believes high-yield products will offer price appreciation as spreads should tighten. On the global economic environment, Mr. Buchanan echoed Western Asset views that interest rates are poised to rise – albeit slowly, and via a process that will be carefully measured. Rates will not be meaningfully higher in the near future, or at least the moves will be gradual.

"We've benefited from a very supportive Fed," Mr. Buchanan said. "They want to be thoughtful and careful, and we think the Fed will continue to be in play even as they step away from this extremely accommodative environment. That's good for investors. When rates are not a huge threat, it makes the water safer for fixed-income in general and credit in particular."

He believes high-yield markets will remain attractive for some time.

"The fundamentals have been driving the long-term rally we're experiencing," Mr. Buchanan said.

"Fundamentals remain very strong. Valuations have created near-term opportunities. We've been seeing really supportive numbers, even with recent volatility in rates. Yet this volatility is spilling into other asset classes, creating opportunity. Yields have increased. Default rates are close to historical lows and likely to stay at or near these abnormally low levels. We are advising clients to take advantage."

In Mr. Buchanan's view, the best way for investors to take advantage is through active investment.

"A diversified approach is really important," he said. "I know there's a lot of money in ETFs and other passive products, but we don't advise going that way. Success in the high-yield markets is an active investing story. Big, strong research capabilities are essential to understanding the more esoteric details and acting upon them. Unlike passive strategies, we do not want to buy the whole market. Many poor investments get made that way. We want to pick only the best opportunities for our clients."

To illustrate, Mr. Buchanan identified Western Asset's thinking in several areas.

"Right now we are underweight European high-yield and overweight U.S. high-yield, given their stronger fundamental underpinnings," he said. "The U.S. looks very attractive. The oil sector is under a lot of pressure but we see some opportunity there, in the right bonds. On the whole we're using this pullback to pick up some high quality companies at bargain prices."

Mr. Buchanan is also underweight in the technology sector: "Technology is a great equity story but at Western Asset we are always looking for stable, consistent, predictable cash flows, we want to get our coupons and ultimately we want to get paid back at maturity. When you have that volatility of cash flows it makes us steer clear or at least be a little more cautious."

He also advised being careful about duration.

"If you don't have to take excess duration, if you can get your yield and not have to take a lot of interest rate risk, that's pretty appealing," Mr. Buchanan counseled. "Bank loans and short-dated high-yield look pretty good right now."

There have been suggestions that high-yield markets are overvalued, but Western Asset does not agree.

"There is a camp out there that thinks high-yield is in a bubble, but the arguments supporting that are hollow," Mr. Buchanan explained. "Investors have to look at yields compared to other fixed-income products. Those spreads are positive. The fundamentals are strong. I know the attributes of a high-yield bubble and the current market does not have them."

Still, Mr. Buchanan counsels vigilance.

"The kind of volatility blips we've had recently will test your conviction," he said. "Liquidity has been touted as an issue in a market where dealer balance sheets are more constrained, but reduced liquidity does not affect our normal process. Western Asset's in-depth credit research process has always been the foundation of our investing. Thus we are comfortable throughout a credit cycle with each of our holdings, since they are not designed to capitalize on trading volatility. Smart investors should take all of that into consideration, as we do."

All this leads Western Asset to be positive in its outlook of today's high-yield markets.

"You start with the fundamentals," Mr. Buchanan advised. "Whether you're talking interest rate coverage, leverage, free cash flow generation, default rates: all of these are very supportive for credit and haven't really changed. The trajectory seems to be going the right way. Then you contrast that with valuations. We measure it on a spread over Treasuries basis but we're still cheap to historical averages. Put those two together and we see opportunity."

About Michael C. Buchanan, CFA

Mike Buchanan is the Head of Global Credit at Western Asset Management. He joined the firm in 2005. Mr. Buchanan previously served as Managing Director and Head of U.S. Credit Products at Credit Suisse Asset Management, and as Executive Vice President and Portfolio Manager at Janus Capital Management. He also worked at BlackRock Financial Management as a managing director and portfolio manager, and at Conseco Capital Management as a vice president and portfolio manager. Mr. Buchanan graduated with a B.A. from Brown University.

About Western Asset Management

Western Asset Management is one of the world's leading fixed-income managers with $472 billion in assets under management as of September 30, 2014. The firm is a wholly owned, independently operated subsidiary of Legg Mason, Inc. (NYSE: LM) From offices in Pasadena, Hong Kong, London, Melbourne, New York, Sao Paulo, Singapore, Tokyo and Dubai, the company provides investment services for a wide variety of global clients, across an equally wide variety of mandates.

About Legg Mason
Legg Mason is a global asset management firm with $708 billion in assets under management as of September 30, 2014. The Company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange (NYSE: LM).

Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rises the value of fixed-income securities falls. High yield bonds possess greater price volatility, illiquidity, and possibility of default. International investments are subject to special risks including currency fluctuations as well as social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Duration is a measure of the price sensitivity of a fixed-income security to an interest rate change. It is calculated as the weighted average of the present values for all cash flows, and is measured in years.

A basis point (bp) is one one-hundredth of one percent (1/100% or 0.01%).

The views expressed are those of the author of the date indicated, are subject to change, and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. All data referenced are from sources deemed to be reliable but cannot be guaranteed.

SOURCE Legg Mason, Inc.