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:
- A persistent source of income;
- Higher risk-adjusted returns than traditional core bond exposures; and
- 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.1 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: Bloomberg Finance L.P., as of 12/31/2018 based on the return of the ICE BofAML US High Yield Index. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.
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.2
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.
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 the 100% aggregate exposure, but higher returns.
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). The negative treasury correlation 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.3 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.
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.
For investors seeking high yield bond exposure, SPDR® ETFs offer a comprehensive family of funds, including the SPDR ICE BofAML Broad High Yield Bond ETF (CJNK).
1Based on the yield to worst from 02/1999–02/2019 for the Bloomberg Global Aggregate Bond Index and the dividend yield for the MSCI ACWI Index versus the yield to worst of the ICE BofAML US High Yield Index.
2Bloomberg Finance L.P., calculations by SPDR Americas Research. P-value on two-sample T-stat test is below 5% assuming a 95% confidence interval.
3Bloomberg Finance L.P., as of 02/15/2019.
Bloomberg Barclays EM USD Aggregate Bond Index
A benchmark that tracks the total returns for external-currency-denominated debt instruments of the emerging markets.
Bloomberg Barclays Global Aggregate Bond Index
A benchmark that provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the US Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment-grade 144A securities.
Bloomberg Barclays US Aggregate Bond Index
A market-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most US traded investment grade bonds are represented. Municipal bonds and Treasury Inflation-Protected Securities are excluded, due to tax treatment issues. The index includes Treasury, Government agency bonds, Mortgage-backed bonds, Corporate bonds and a small amount of foreign bonds traded in the US.
Bloomberg Barclays US Corporate Bond Index
A fixed-income benchmark that measures the investment-grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
Bloomberg Barclays US Treasury Index
An index that covers the entire US government bond market by containing US Treasuries with maturities ranging from 1 to 30 years.
The historical tendency of two investments to move together. Investors often combine investments with low correlations to diversify portfolios.
High Yield Bond, or Junk Bond
A high paying bond with a lower credit rating than investment-grade corporate bonds, Treasury bonds and municipal bonds. Because of the higher risk of default, these bonds pay a higher yield than investment grade bonds.
ICE BofAML High Yield Index
The index tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds publicly issued in the US domestic market.
S&P Small Cap 600 Index
An index that tracks the small-cap segment of the US equity market. The index is designed to track companies that meet specific inclusion criteria to ensure that they are liquid and financially viable.
T Stat Test
A t-test is a type of inferential statistic used to determine if there is significant difference between the means of two groups, which may be related in certain features.
Yield to Worst
The lowest potential yield that investors can expect when investing in a callable bond without the issuer defaulting.