Clients often push back on allocating to high yield as they deem it the highest risk part of the fixed income asset class and don’t give it much more thought. It’s a question I get in almost every client meeting – why high yield, and why now?
There are a couple of characteristics of the high yield asset class that make it stand out. One is duration. At a headline level, the average duration of the asset class is low at just 3.4 years, but dig a little deeper and you will find that the asset class actually has very little correlation to interest rate risk. This makes sense given the low level of duration that the asset class has, but it also highlights the fact that high yield portfolios are constructed of sub-investment grade corporates that should behave more in line with their business fundamentals as opposed to the direction of the risk free rate.
With this in mind, high yield has a greater level of correlation to equities than it does to traditional fixed income, but the returns between the two may surprise you. As you will see below, US High Yield has delivered over 80% of the returns of the S&P 500 over the last 30 years with less than half the volatility. In fact, it has returned the same over 20 years with once again less than half the volatility. So why exactly does high yield offer such strong risk adjusted returns over time?
Part of the reason is quite simple: bonds mature, equities don’t. As a result, bonds, particularly ones with low amounts of duration, can only deviate so far from par before the price ‘snaps back’ thanks to simple bond mathematics. As a result, in times of weakness, while high yield will be highly correlated to equity markets, it snaps back a lot quicker – it is not reliant on multiple expansion or mean reversion of equity multiples. Investors, therefore, should be less concerned about how cheap or expensive the asset class looks when almost all your return is made from income. High yield is an asset class with strong foundations; it doesn’t really experience much of a ‘dip’ to buy into.
Indeed, a move to ‘fair value’ in high yield (as measured by the asset class moving to average 20-year spreads), would result in 2% capital loss whereas, if you do the same for the S&P 500 (taking the average 20-year P/E multiple), it would be around a 14% loss. This is why in the last 30 years, there has never been two consecutive years of negative returns for US high yield – a remarkable statistic.
As we look towards 2020, the compounding returns of high yield, which offer compelling risk-adjusted returns through the cycle, will likely be a key consideration from an equity de-risking perspective.
Source: Bloomberg June 2019