The strategic case for a long-term allocation to high yield

May 16th, 2019 | By | Category: Fixed Income

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By Matthew J. Bartolini, Head of SPDR Americas Research, State Street Global Advisors.

Matthew J Bartolini, Head of SPDR Americas Research

Matthew J Bartolini, Head of SPDR Americas Research.

Based on key systemic and persistent traits, high yield corporate bonds should be viewed as a strategic asset class within the portfolio construction process – even if the flow patterns within high yield ETFs indicate a more tactical investor mindset.

Those tactical shifts, after all, are commonly expressed from a strategic base with investors then dialing up or down the level of credit risk within a portfolio based on the market risk regime (euphoria to normal to crisis), where we are in the corporate profit/default cycle, and where valuations (cheap or rich to historical averages) currently stand.

The strategic case for high yield is grounded in three areas:

  1. A persistent source of income
  2. Higher risk-adjusted returns than traditional core bond exposures
  3. Low correlations to traditional bond segments, improving diversification opportunities.

In addition to discussing these three traits, I will also touch upon implementation considerations for a strategic position to high yield, focusing on the merits of an indexed-based versus active approach.

Strategic case #1: Clipping coupons

Based on demographic shifts and a persistent low yield environment, income generation is an outcome targeted by many investors when constructing portfolios today. High yield is an asset class that should be at the center of any income-generating portfolio, just by virtue of it carrying a yield 63% higher than that of the combined yield of global aggregate bonds and global equities, on average, over the past 20 years.

That yield is not without risk, as the higher yield stems from being below investment grade and having higher credit risk. There is no free lunch, and there have been times over the past 30 years where high yield, in a single year, was down more than 10%, essentially wiping out any of the high coupon earning in that year. But we are not talking about investing for a single year. We are looking at the strategic benefits of high yield as an asset class and its income-generating properties over the long term.

While those negative price return years can be troubling in the moment, the chart below underscores the case for a long-term allocation as a result of the “coupon” or income being the predominant driver of returns over the long haul. In the chart below we can see that as the time frame is extended, the percentage of return attributed to the coupon is nearly always close to, if not more than 100%. The 10-year figure is the outlier as a result of the starting point of this periodic return being the bottom of the financial crisis, leading to higher gains from a price return perspective as the market has rebounded over the last decade.

Source: SPDR ETFs.

Another way to depict the relationship between coupon and return is in the chart below. In this chart, we plotted the index yield to worst for the ICE BofAML US High Yield Index at a point in time and then the index’s subsequent five-year return, showing how the yield offered in the market has a strong relationship to determining the future returns. These two time-series have a 74% correlation over the period measured.

To add more robustness in depicting the closeness of this relationship we ran a t-stat test to show how the variance between these two variables is not significantly greater than zero, meaning there is a strong relationship between the current yield and future returns.

Source: SPDR ETFs.

Source: SPDR ETFs.

Strategic case #2: Higher risk-adjusted returns

Relative to traditional bond categories, high yield corporate bonds offer higher risk-adjusted returns, carrying a Sharpe ratio of 0.66 over the last 15 years compared to 0.38 for global aggregate bonds and 0.52 for US Treasuries. There is also the aspect that high yield, historically, has earned similar returns to US stocks (7.2% versus 8.9%) but with less volatility (8.99% versus 13.5%)—or rather, a minor 13% less return but with 34% less volatility. The chart below shows the difference between risk and return across these major asset classes.

Source: SPDR ETFs.

Source: SPDR ETFs.

As a result of this risk and return profile, adding high yield exposure to an aggregate fixed income exposure has historically benefited performance by increasing returns while not overextending on risk. This can be seen by examining the efficient frontier of a mix between high yield and core aggregate bonds, shown below. The curved frontier shows the benefit of high yield, in that the 20% high yield / 80% aggregate portfolio has the same risk as to the 100% aggregate exposure, but higher returns.

Source: SPDR ETFs.

Source: SPDR ETFs.

Strategic case #3: Low correlation profile

One of the reasons for the shape of the efficient frontier above is the correlation profile of high yield bonds relative to traditional bond sectors. Since 1990, using monthly return data, high yield bonds have had a negative correlation to Treasuries (-0.06) and very low correlation to both US (0.24) and global aggregate bonds (0.27).

FEATURED PRODUCT

SPDR ICE BofAML Broad High Yield Bond ETF (CJNK US)

– Tracks the ICE BofAML US High Yield Index, providing
broad exposure to over a trillion dollars of USD-denominated
high yield debt, covering more than 1,800 issues.

– The index includes high yield bonds with at least one year
remaining to maturity, a fixed coupon schedule, and a
minimum amount outstanding of $250 million.

– The index currently has an average coupon of 6.4%;
a current yield of 6.5%; and option-adjusted duration of
3.6 years.

– The fund comes with an expense ratio of 0.15% and
AUM of $72 million.

The negative correlation to Treasuries is also an indication of the low-interest rate sensitivity high yield has, a feature that has been a benefit during rising rate periods – provided growth remained positive and corporate fundamentals were healthy.

Therefore, from a portfolio risk perspective, this allocation away from Treasuries or aggregate bonds to high yield changes the risk dynamics of the portfolio, as its swapping interest rate for credit risk, further increasing the diversification profile of a portfolio as “risk bets” are now more evenly distributed.

Index-based strategies may be more compelling than active for high-yield exposure

When considering index-based vs. actively managed high yield strategies, there is strong evidence that active management may not be the best choice for strategy implementation. Active managers have historically struggled to beat their respective benchmarks in the high yield space, and consistent outperformance is very rare.

In 2018, 67% of active high yield managers underperformed their benchmark while still earning $1.6 billion in fees as they did. As shown below, 42% of active high yield managers have underperformed each year for the past three consecutive calendar years. So while persistent outperformance is rare, persistent underperformance clearly is not.

With a lower cost than active and an objective of seeking to track a benchmark, an index-based approach may be more compelling as the high costs of an active strategy can accumulate over time, and active manager performance may be challenged depending upon the market regime.

Source: SPDR ETFs.

Source: SPDR ETFs.

Taken together, these considerations make a strategic long-term allocation to high yield attractive from both a portfolio diversification and return (i.e. income generation) perspective, with index strategies positioned as particularly compelling due to the consistency of active manager underperformance. Not surprisingly, in our global allocation portfolio we hold an indexed exposure to high yield in the portfolio at a strategic weight of 6%, and will tactically position based on the current market environment.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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