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What are high yield bonds? I don’t mean the textbook definition (corporate bonds with a credit rating below BBB), but how they actually behave in terms of risk and return.
In attempting to answer this question, let’s address some common myths surrounding the asset class affectionately known as “junk bonds.”
Junk bonds are bonds, so they should act more like other bonds than stocks, right?
Wrong. With a correlation to stocks of 0.58 and a correlation to bonds of 0.24, junk bonds are more likely to move with the U.S. stock market than the aggregate bond market.
When junk bonds are down more than stocks (13% of all months), we often hear that they are riskier than stocks. While that may appear to be the case at times, their overall risk profile does not support such a conclusion:
Just because junk bonds are correlated with stocks over the long run doesn’t mean they always move in the same direction. Historically, they have moved together in 76% of months. That means in roughly 1 out of every 4 months, or 3 times per year on average, they are moving in opposite directions.
Interestingly, much of this differential behavior seems to occur in months when stocks are down. During such months high yield bonds have actually been positive 47% of the time. In contrast, during months when stocks are up, high yield bonds have been up 88% of the time.
The greatest fear of most bond investors is higher interest rates, and they naturally extend that fear to high yield bonds. Historically, has that been a valid concern? No.
High Yield bonds have actually performed better during periods of rising rates (9.2% annualized return) than falling rates (7.7% annualized return).
How is that possible? Well, high yield bonds have a shorter maturity and higher coupon than long-term treasuries and investment grade corporate bonds. As a result, they have a lower duration, meaning less sensitivity to rising rates. Additionally, when interest rates are rising, it can be a sign of an improving economy. The price appreciation in junk bonds (spread tightening) can more than outweigh any negative impact from higher rates.
Now that we have a handle on how junk bonds behave, how should an investor think about their current risk/reward profile?
With a yield of around 5.5% (close to all-time lows), at the very least investors should be expecting below-average returns going forward. Beginning yield tends to be a decent predictor on that front. Generally speaking, the higher the starting yield, the higher the prospective returns, and vice versa.
Given low current yields, hitting the 8.7% historical average return over the next five years would not only require a default-free environment but additional spread tightening as well. With spreads already at their lowest levels since 2007, that would be a lofty expectation to say the least.
Not necessarily. The tight credit spread environment and low prospective returns for junk bonds are not occurring in a vacuum. They are coinciding with a richly valued equity market that many argue will also lead to below-average forward returns.
What it comes down to, then, is what you believe is the most likely scenario going forward:
History supports such a view. Junk bonds have put on their best relative performance versus stocks in the years following equity market peaks in 2000 and 2007. Conversely, their worst relative performance came during the late 1990s when U.S. equity valuations reached their most extreme levels in history.
From 1995 through 1999, junk bonds gained 60% versus an astounding 250% return for the S&P 500. The spread over the past five years (103% for stocks versus 36% for junk bonds) seems tame by comparison.
That said, the S&P 500 is on pace for its 9th consecutive up year, tying the record run from 1991-1999. Valuations are at their most elevated level in history with the exception of the dot-com bubble. It wouldn’t be unreasonable for less risk-tolerant investors to be seeking out lower beta options in preparation for more difficult years ahead. High yield bonds have proven to be one such option over the past 30 years, displaying lower volatility, lower drawdowns, and significantly lower downside capture versus the broad equity market.
Potentially missing out on further upside should equity valuations continue to expand. Junk bonds are still likely to be positive in such an environment but could significantly lag the returns from equities. Unfortunately, that’s an unavoidable risk – for in order to protect capital on the downside. You have to be willing to give up some upside in return. There’s no other way.
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This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. It also does not offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing. All data for Gold used in this piece is from stockcharts.com and is continuous futures data which combines multiple futures contracts to create a smooth price series.
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors. He previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University. He has also done a B.A. in Economics from Binghamton University. Charlie holds a J.D. and M.B.A. in Finance and Accounting from Fordham University. He has also done a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and also holds the Certified Public Accountant (CPA) certificate.
In 2017, Charlie was named the StockTwits Person of the Year. He is a frequent contributor to Yahoo Finance and has been interviewed on CNBC, Bloomberg, and Fox Business.
You can follow Charlie on twitter here.
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