Much has been written about today’s prolonged low interest rate
environment and how it has prompted many investors to seek out riskier
assets in an attempt to generate a return that exceeds inflation. One
big beneficiary of this trend has been high yield. This year through the
end of September, $38 billion has flowed into high yield mutual funds
and ETFs, and last week,
Russ cautionedthat high yield was looking expensive.
Most investors are aware that high yield bonds have greater credit
risk than many other fixed income sectors. But what might be less
appreciated – especially by investors who are new to high yield — is how
challenging high yield liquidity can be at times, and how rapidly high
yield bond prices can fall in a deteriorating market.
Take a look at the chart below. It’s a six-month snapshot of the 2008 financial crisis, and it illustrates how
bid/offer spreads
on high yield bonds may widen as the market deteriorates. The dark blue
line shows the market value of the Barclays US Corporate High Yield
Index. The light blue line shows the average bid/offer spread of bonds
in the high yield market. Notice how the market sell-off was
accompanied by rising transaction costs for high yield securities.
Investors also need to understand the high yield market’s
“equity-like” characteristics. For instance, when high yield sells off,
it tends to do so in a “risk-off” market in which other higher risk
investments, like equities, are also selling off. This drop in value
during a stock market decline can be an unwanted surprise for investors
who expect the bond portion of their portfolio to rise in value during a
risk-off market and to help shelter the overall portfolio from the
impact of a market dislocation.
Let’s look at two examples of this kind of dislocated market: the
2008 financial crisis and the US Treasury downgrade in August 2011.
Over the past five years (October 2007 – October 2012), the
correlation
between high yield and the S&P 500 has been approximately 0.62.*
However, during the onset of the financial crisis from 9/15/08 –
10/15/08 this correlation increased to 0.79. More recently, in the
aftermath of the US Treasury downgrade during August 2011 the
correlation jumped to a whopping 0.97 – meaning that high yield and
equities were moving almost in lockstep with one another.
What does this mean for investors? High yield can be a good asset
class for building yield into a portfolio, but it does not have the same
diversification properties that are often looked for in a bond
investment. This is especially true during falling equity markets when
such diversification may be desired most. This is not to say that
investors should shun high yield as an asset class. Indeed, any higher
yielding asset is likely to exhibit similar behavior. Rather, investors
should set realistic expectations for yield targets and obtain that
yield from diversified sources (e.g., high yield bonds, EM bonds,
dividend stocks, long duration US Treasuries or corporates).
In the end, yield is never free. It is just a question of what risks
an investor wants to take and how they construct their portfolio.
*Correlations were calculated using daily observations between the market price of
HYG and the S&P 500.
With
continued volatility in global markets, top Citi analyst Tom
Fitzpatrick put together a group of charts and commentary to help put
things in perspective for investors around the world. There are a
series of fascinating charts in this piece. Fitzpatrick also takes a
trip back in time to use as a roadmap for the future.