When to Fear High Yield
In recent weeks, high yield bonds have traded lower and their spreads versus risk-free Treasury bonds have widened to their highest levels since 2011. The financial media responded as expected, with fear-inducing coverage warning of impending doom. The entire junk bond asset class was maligned, along with the ETF structure, with Carl Icahn leading the charge.
To be sure, rising credit spreads from ultra-low levels can be harbinger of bad things to come, but pointing this out ex-post (after the fact) does little good to the average investor. And provoking panic in an entire asset class is just about the worst thing you can do.
If not ex-post, when should investors start worrying about high yield? A good start would be when the name “high yield” is a misnomer – when yields and credit spreads are at extreme lows. At such levels, there is little cushion for future defaults, and the risk/reward is skewed to the downside.
We faced such conditions in June 2014, as I wrote in the following tweets.
We have data on the BAML High Yield Index going back to 1986. The best predictor of future return: beginning yield (see chart below). When yields hit all-time lows in June 2014, the message was clear: expect lower returns going forward.
The same could be said for credit spreads, which hit cycle lows of 335 basis points (3.35% above risk-free Treasuries) in June 2014. At their December wides, they had more than doubled from these lows, at 733 basis points.
To be sure, low yield and spread alone does not tell you when a default cycle is about to occur. They can stay below average for years without a commensurate pickup in defaults. What low yields and spreads are telling you, though, is that you are no longer being paid to take such risks; the risk/reward has changed.
The average yield to maturity in High Yield Bonds since 1996 is 9.5% while the average spread above government securities is 577 basis points. Yields crossed above 9.1% this month with spreads at a peak of 733 basis points. While still slightly below average in yield, spreads are now above average.
The key point here is that, in contrast to June 2014, you are now being compensated for the risk of higher defaults. The increased fear of high yield is a good thing for investors as it has pushed prices down and yields/spreads higher.
To be sure, if we enter into a recession in 2016, spreads are likely to widen further but that doesn’t change the math: buying junk bonds today is a much better risk-reward than in June 2014. And to the extent that current yields/spreads are already pricing in higher defaults in 2016, should a recession not materialize we could see spreads actually tighten during the year, providing an additional boost to returns.
As for the notion that High Yield bonds are a flawed asset class that has no place in a long-term investor’s portfolio, history has shown otherwise.
Since 1986, high yield bonds have delivered an annualized return of 8.3% versus 8.5% for the Russell 2000 and 9.9% for the S&P 500. Nothing to write home about, but in risk-adjusted terms it is quite impressive. With annualized volatility of 8.2% in High Yield versus 15.2% for the S&P 500 and 19.5% for the Russell 2000, risk-adjusted returns are far superior.
Also notable is that high yield bonds have historically experienced significantly lower drawdowns than equities, a fact that seems to be completely lost in the current discussion. If you are afraid of high yield bonds today – which are higher up in the capital structure – you should really be afraid of equities.
A keg of dynamite?
“The high-yield market is just a keg of dynamite that sooner or later will blow up. The ETFs are very dangerous. The average person that goes into this should basically be warned and understand the danger.” – Carl Icahn on CBNC, December 14, 2015
Carl Icahn recently asserted that the high yield market is a “keg of dynamite” and high yield ETFs are “very dangerous.” Strong words indeed, coming from the chairman of Icahn Enterprises, whose stock has declined 32% in 2015 versus a 5.3% decline for the largest high yield bond ETF (HYG).
Back in 2008, the worst year in history for High Yield, the High Yield ETF (HYG) declined 17.6% versus a decline of 38.2% for the S&P 500 ETF (SPY) and 79.6% for Icahn Enterprises (IEP). If another 2008 in high yield is coming, as Icahn has suggested, the more rational fear for investors would seem to be in equities.
When to Fear High Yield
Which brings us back to the title of the article: when to fear high yield. Regardless of your outlook for 2016, the time to be most afraid of high yield is when yields and spreads are low. If 2016 is another 2008 and the U.S. enters a recession, yields and spreads will rise and high yield bonds will certainly fall further from here. But that doesn’t change the fact that investors are better positioned for this scenario today than they were in June 2014 when spreads/yields were at their lows.
It also stands to reason that if you are afraid of a 2016 collapse in high yield, you should be more afraid of a collapse in equities which are the riskier asset class that is lower in the capital structure.
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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
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