High yield bonds have returned 1% so far in 2018 on a total return basis. Strong corporate earnings growth combined with unemployment below 4% and US GDP growth above 3% has created a modestly constructive environment for risk assets, like high yield.1 Returns would likely be even higher if they weren’t being constrained by tighter monetary policy and ongoing geopolitical uncertainty.
In comparison, investment grade credit is struggling. The sector has fallen 2.5% this year, as its performance has been weighed down more heavily than high yield by rising interest rates.2
However, while income-seekers may consider flocking to high yield for its elevated coupons, investors should be aware that risks are lurking and the high yield market is looking stretched. The following charts capture the current state of high yield and help to illustrate why senior loans may offer a more ideal solution for today’s income-seeking investors.
High yield and investment grade: Volatility profiles flip
In today’s market, which features a tempered risk-on environment where interest rate movements have been a larger harbinger of negative performance than credit risk, the volatility profiles of investment grade and high yield have flipped.
As shown below, the 3-month implied volatility (the market’s forward-looking expectation of volatility based on options prices) for high yield bonds has fallen below that of investment grade. The spread between the two has fallen well below the 10th percentile over the last five years—a potential signal that mean reversion may be in store.
However, this volatility profile flip isn’t constrained to implied volatility. It applies to realized volatility as well, which is captured below. While not below the 10th percentile, the difference between the two bond sectors’ realized volatility is well below the historical median, and near the 10th percentile.
This low volatility regime for high yield, both in absolute and relative terms, has led to more risk-taking among investors. As a result, the Relative Strength Index (RSI), which measures investor euphoria, has surged on a basket of high yield bonds to well above overbought levels of 70. Today the chart below shows it is sitting in overbought territory of 79. In the last five years, high yield’s RSI figure has only spent an average of five days north of 70. August 8, 2018 marks the 7th day above the overbought mark, providing another signal that a reversion to the mean may be on the horizon.
High yield spreads have also continued to tighten. Shown below, they are currently sitting 35% below the 20-year median and are hovering around the lowest 10th percentile. Spreads have been range-bound for the last 18 months with fits and starts based on market sentiment. Spread levels this low indicate less upside relative to downside on a forward-looking basis, and high yield’s 1% return in 2018 underscores this trend.
The riskiest high yield tranche
If we look at the CCC-rated tranche of the high yield market, which is the riskiest slice of the market, compared with broad high yield, we see a clear “dash for trash.” The chart below shows the spread between CCC-rated bonds and broad high yield has fallen tremendously, converging by 24% this year alone.
Senior loans: a potential source of income generation
For investors who are seeking income generation but are cautious about the spread levels in high yield, senior loans offer a compelling solution. As shown below, senior loans have a comparable yield and spread to high yield, but a much lower duration. Senior loans’ floating-rate structure, lower equity sensitivity and seniority in the capital structure have resulted in improved drawdowns over the last 18 months.
Historically, if spreads widen, loans have withstood the impact much better than fixed rate high yield bonds. This trend has held true not only amid the worst months of spread widening but also overall. The chart below captures senior loan vs. high yield performance in a given month when high yield spreads have widened over the last 20 years.
Floating rate senior secured loans have outperformed most traditional fixed income categories year-to-date. Coupons on the S&P/LSTA Leveraged Loan Index are at a post-financial-crisis high of 5.47% and are likely to go higher with the Federal Reserve on course to raise rates twice more in 2018.3
As I have discussed previously, investors seeking exposure to senior loans may want to consider using an actively managed ETF like the SPDR Blackstone / GSO Senior Loan ETF (SRLN). SRLN’s active mandate allows for rigorous security selection, providing the potential to avoid loans of poor quality that may be included in an index-based strategy.
1Bloomberg Finance L.P. as of 08/08/2018
2Bloomberg Finance L.P. as of 08/08/2018
3S&P/LSTA as of 07/31/2018
A portfolio management approach that uses a human hand, such as a single manager, co-managers or a team of managers, to select, adjust and change a fund’s holdings over time.
Actively Managed ETF
An exchange-traded fund that has a manager or team making decisions on the underlying portfolio allocation or otherwise not following a passive investment strategy. An actively managed ETF will have a benchmark index, but managers may change sector allocations, market-time trades or deviate from the index as they see fit. This produces investment returns that will not perfectly mirror the underlying index.
Relative Strength Index (RSI)
A momentum indicator developed by noted technical analyst Welles Wilder, that compares the magnitude of recent gains and losses over a specified time period to measure speed and change of price movements of a security. It is primarily used to attempt to identify overbought or oversold conditions in the trading of an asset.
A process where investors move to riskier potentially higher yielding investments and then back again to supposedly lower yielding investments which are thought to have lower risk.
S&P/LSTA U.S. Leveraged Loan 100 Index
A benchmark that is designed to reflect the largest loan facilities in the leveraged loan market. It mirrors the market-weighted performance of the largest institutional leveraged loans based upon market weightings, spreads, and interest payments. The index consists of 100 loan facilities drawn from a larger benchmark, the S&P/LSTA (Loan Syndications and Trading Association) Leveraged Loan Index (LLI).
The tendency of a market index or security to jump around in price. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.