The high yield bond market has more than a 30-year history and has grown from a niche asset class to an established sector with a market value of $1.210 trillion, yet it seems to occasionally elicit a love/hate relationship from market movers and spectators alike. Perhaps by virtue of its hybrid nature – part bond/part stock – there is usually a group of investors that believe the worst is always around the corner. Or maybe it’s difficult for others to forget the colorful early stages of the high yield market in the 1980’s (Michael Milken, the Predator’s Ball, the S&L scandals, etc.) and have trouble reconciling that to the market as it stands in 2018.
No matter how others view the high yield market, we at Performa believe it is an integral part of a captive insurer’s strategic asset allocation. Depending on a captive’s current position in its life cycle, high yield is either a potential next step in asset allocation once surplus accumulation begins or, for more mature captives, a great tool from which to move portfolios up and down the risk spectrum.
In form, high yield bonds are no different than their investment grade corporate bond counterparts that are a staple in many captive portfolios. In purpose and structure, both markets exist to lend money to companies for a variety of uses. The differences between the two, however, are the types of risks and expected returns that a bondholder takes in each category. High yield issuers have lower rated creditworthiness (below BBB ratings level) and subsequently pay higher yields to investors. The consequence is that the high yield market provides a more idiosyncratic return to investors; performance is impacted more by individual issuers and certain sectors rather than the direction of interest rates and corporate bond’s spread relative to U.S. Treasury bonds.
Given that high yield bonds trade primarily on credit risk (as opposed to interest rate risk), the sector can provide diversification benefits when coupled with other bond and equity strategies. For a captive that is beginning to take on more risk, an allocation to high yield bonds can provide an equity-like return, but with less volatility, while diversifying away from interest rate risk. For a mature captive with multiple asset classes, high yield can provide a middle ground between investment grade bonds and equities from a risk and return perspective.
Diversification is a sizable benefit, as is the ability to use a high yield allocation as a tool when adding or reducing overall portfolio risk. In either case, the diversification comes from less correlation (movement in tandem) between credit risk and interest rate risk. Roughly 30 years of data demonstrates that high yield exhibits low correlation (between 50% and 60%) to investment grade corporate bonds and equities. As for interest rate risk, high yield barely follows as its correlations to U.S. Treasuries and Government bonds are less than 10%.
While diversified risk is good, it is only useful if returns are commensurate. Indeed, from July 1983 to November 2018 high yield has produced annualized returns of 8.75%, which was comparable to the S&P 500 and Russell 2000 returns of 10.89% and 9.03%, respectively. What is more telling however, is that over the same time period high yield posted a dramatically lower standard deviation of 8.19% compared to 14.62% for the S&P 500 and 18.82% for the small cap Russell 2000 Index. In other words, high yield has largely kept pace with equities while capturing only roughly half of the volatility (as measured by Standard Deviation).
Bonds with higher coupons can act as a buffer for times when riskier assets (such as stocks) become more volatile or when interest rates are rising. Higher coupons of high yield bonds (interest payments) can help offset negative price movements. In 2014, the high yield market fell more than 4% on a price return basis, yet its total return for the calendar year was a positive 2.45%. Since the yield of the market at the beginning of 2014 was almost 6.6%, there was more than enough income received by bond holders to offset the negative price action. Meanwhile, in 2013, the high yield price return experienced a negligible gain of 0.11%. However, a healthy coupon return of 7.34% provided investors with a total return of 7.45% for the year. 2013 was also the year in which interest rates rose across the yield curve, leading to negative total returns for several investment grade bond benchmarks. For example, the Bloomberg Barclays Intermediate US Government/Credit Index generated a return of -0.86% while the Bloomberg Barclays US Aggregate Index was -2.02% for the year.
Since Q4 2001, there have been 15 periods when the yield on the 10-yr U.S. Treasury had risen more than 50 basis points. During those periods of rising interest rates, the high yield market generally performed quite well, producing positive absolute total returns in 12 out of 15 instances and outperforming investment grade bonds 14 out of 15 times. Part of that has to do with rising rates being indicative of an improving economy which is usually better for lower quality bond issuers as well as stocks. Rising profitability and balance sheet improvement is especially relevant to high yield issuers as they gain greater flexibility to refinance their existing debt at lower yields and may even become investment grade credits (rising stars). Overall, a rising economy is an environment where bond defaults should remain subdued and investor demand should be supportive of spreads.
The United States is in the midst of the second longest economic expansionary cycle in its history (1991-2001 is the leader). Year-to-date default rates (see Chart 4 below) through November 2018 fell 0.17% to 1.87% and remain well below the long-term average of ~3.5%. Stripping out iHeart Media’s $16 billion default earlier this year, the rate is only 1.14%. Leverage ratios remain in check and upgrades continue to outpace downgrades, all of which should remain supportive of credit as long as company earnings stay upbeat and the economy continues to chug along for the next few years.
The high yield market should continue to benefit from muted new issue supply as a large portion of the new issuance market is either refinancing existing debt or refinancing into the high yield loan market. While there will always be cyclicality in prices and yields across bond markets, and in the high yield bond market in particular, the sector has proven throughout multiple cycles that it should be an integral part of a client’s asset allocation strategy. An actively managed high yield bond portfolio that seeks to preserve principal by managing credit risk can provide good diversification and low correlation amongst other fixed income and equity strategies. Additionally, the sector provides attractive risk adjusted returns and lower sensitivity to changes in interest rates, which is especially important in a rising rate environment.
After tirelessly lifting weights for three plus years we have attained the desired results. As such, it is time put down the barbell and move investment grade fixed income portfolios closer to neutral duration. While the average body type of a Performa employee can hardly be described as chiseled, our investment grade fixed income portfolios have been doing some heavy lifting. The short duration and barbell strategy employed for the last few years has been a positive for index relative performance as easy monetary policy abated and interest rates rose from historical lows.
For the last three years, Performa’s investment grade fixed income portfolios have been positioned in anticipation of higher interest rates and a flattening yield curve (i.e., the gap between short and longer term yields decreases). This positioning has consisted of being short duration vs. the index combined with a barbell – owning floating rate bonds on the short end of the yield curve and longer fixed rate instruments on the other. Our investment thesis was twofold, we would maintain our short duration, barbell stance until 1) interest rates reached our equilibrium target of approximately 3%, and 2) selling our floating rate holdings for fixed rate securities achieved the right risk/return profile.
Throughout the current rate hiking cycle we have continually examined the relationship between floating rate yields and U.S. Treasuries, checking to see if the above two conditions had been satisfied.
For example, in early April it would have cost portfolios roughly 8 basis points of yield to remove the barbell (sell the floaters) and buy 2 to 3-year U.S. Treasuries. Back then, both 3-month LIBOR and 2-year U.S. Treasuries were around 2.25%. Although there was no difference between the two in yield, the market was not at or near our 3% target therefore positioning was left unchanged.
Fast forward to today and prevailing market conditions are significantly different. The spike in LIBOR rates that occurred between last fall and the spring has flat lined, and the Federal Funds rate now sits at 2.25%. Meanwhile, the yield on 2-year U.S. Treasuries all the way out to 30-year U.S. Treasuries have compressed around 3%. Therefore, we now feel it is time to unwind the barbell by selling floating rate corporate bonds, and buying longer, fixed rate assets.
Our objective is to achieve the following results:
While the nature of this unwind will naturally extend the overall portfolio duration, we are not taking portfolios all the way back to neutral. We feel the business cycle does have further to run and there is a back drop of the ballooning U.S. deficit with implications for Treasury issuance down the road. Lastly, markets tend to overshoot in both directions. While our equilibrium target of 3% is at hand, it is possible that interest rates spike briefly as positions unwind – that would typically be a good time to bring investment grade bond portfolios back to neutral.
As always, we will keep you apprised of any significant changes in our investment thesis, but please do not hesitate to contact us with any questions in the meantime.
We think the above hip-hop lyric succinctly sums up the first quarter of 2018. The market’s ode to the genre is timely as Kendrick Lamar just wrapped up the first Pulitzer Prize in music ever won by a hip-hop artist. The first quarter of 2018 was a battle. With the hype of tax cuts, stashed offshore dollars coming home and all other things Trumpian, equity market participants chose their sides, suited up, and entered the ring.
Early January was a bull market continuation until the Bears started throwing haymakers. With U.S. led global monetary tightening trends and mounting political and geo-political risk in their corner, the Bears took charge and pummeled the market with large flurries of volatility. Bulls played defense and counterpunched with soon-to-be announced solid Q1 earnings potentials and bags of money that should line shareholder pockets over the coming 12 months.
Who won? Let’s call it a stalemate for now as the S&P 500 return was only slightly negative for the quarter.
However, we believe that gravity has taken hold. Q1 will likely represent the cycle top for equity markets, with the S&P 500 rising to just below 2900 index points. It would take a Herculean effort to pierce this ceiling during the remainder of the year and any attempt to breach those January highs that falls short is certainly a double top indicator and a selling opportunity.
The first quarter might not have been the epic Ali vs Frasier type of bout, but certainly a more pedestrian Holyfield vs Tyson fight seems like a reasonable comparison.
For the past few years, the equity market mantra has been “buy the dips”. The theory has been that economic fundamentals, easy money and new fiscal stimulus provide significant tailwinds for equity valuations in the absence of being able to find returns in other asset classes. Previous downturns were quickly met with large buying programs and stock buybacks, working to reverse losses within weeks. Additionally, price volatility fell to historically low levels.
That dynamic changed in the first quarter. As Bulls and Bears exchanged body blows, the path forward for equity markets became less certain. The underlying belief in higher prices waned and for the first time since early 2016, we saw two-way risk being priced in the marketplace as volatility violently spiked higher.
While consensus has not fully moved to “sell the bounce mode” yet (likely waiting for another attempt to sell closer to the January peak), “buy the dip” has become a more onerous proposition. This simple, yet subtle shift in sentiment has significant market implications and is one of the factors behind our belief that equities have seen a top.
In our opinion, the return of two-way risk in equity markets has been long overdue and is certainly a welcome and healthy development. Suppressed volatility over intermediate periods of time shows complacency, which is both unhealthy and sets the table for future shocks. It also contradicts the need for inflated valuations, driven by years of experimental quantitative easing, to reverse course as the tide of easy money goes out with shifting central bank policies.
Moreover, these evolving equity market dynamics have left interest rates caught in the crossfire. Bond markets are dealing with their own conundrum of positive and negative influences. On the positive side of the equation is shrinking corporate supply due to offshore profit repatriation and the potential for corporate balance sheet improvement. Additionally, the massive yield differentials versus other sovereign debt remains a positive for U.S. rates. On the negative side is ever increasing U.S. Treasury supply in the face of reduced Fed purchases and tax cuts that will balloon the deficit fairly soon. Oh yes, the Fed is hiking interest rates and commodities have been grinding higher too!
Interestingly, while rates are higher over the past nine months and bond prices have fallen, there is a point at which enough equity market selling causes the bond market to retake its safe-haven status from time to time.
Investors will retreat to their corners during the first half of the second quarter with eyes glued to corporate earnings and economic data, like in the good old days. However, it would not be surprising to see the boxing ring lights fire up again mid-quarter or earlier. If earnings do not meet expectations and the beneficiaries of repatriated cash ends up in the hands of bondholders through corporate balance sheet cleanup and not with shareholders via more dividends and new buy back announcements, then the Bears will come out swinging again.
In any event, the challenge for all investors is to stay focused and not get distracted by the daily presidential tweet storms and look out to the horizon. Maybe the #deletefacebook movement could morph into #deletetwitter and the noise would fall ever so slightly.
Looking at the next nine months, there are still a few reasons to be optimistic. The current economic expansion will not end this year as key economic indicators remain constructive, favoring the muddling-along characteristics that have defined this elongated cycle. Some early indications from Q1 earnings have been positive. And perhaps Q2 earnings will be even more telling since earnings are backwards looking. Additionally, looming mid-term elections may be supportive. Grid lock has to be better than what we have seen over the past year. 2019, however, is looking more ominous. Be wary of following the dip buying mentality and carry a heavy dose of skepticism.
* “Lose Yourself” (Eminem, 2002)