16.04.2019 reading time: 7min
Investors, in order to reduce the overall portfolio risk, should consider the possibility of increasing exposure to high-yield bonds, which traditionally have been a reliable early indicator of market problems.
Over the last 20 years, high-yield credit spreads – additional investor income due to having highly risky assets instead of safer public debt – have widened before every major sell-off in capital markets, including Russia’s default in 1998, the dot.com bubble bursting or the global crisis from 2008.
After reaching the lowest level of 303 basis points on October 3, 2018, the spreads have expanded by more than 200 basis points over the next three months. In the period preceding the 19% drop on the S & P 500, the spreads narrowed, which may have been due to the relatively smaller number of bonds issued in 2018, which in turn resulted in a mismatch between demand and supply and an increase in bond prices.
We are approaching the end of one of the longest credit cycles in history, and the yield curve in the US is getting worse and worse – historically it is a signal of slower growth or recession.
Therefore, we think that high profitability may have reacted more slowly than usually, because the October sale, at present, may be treated as a correction or the beginning of a longer downward impulse, which, of course, may change.
Taking the opportunity, it is good to remind investors that combining stocks and high-yield bonds can reduce the overall risk when market conditions deteriorate without the need to sacrifice a part of the rate of return.
Income that is high and consistent First of all, high-yield bonds provide investors with a steady stream of income that can be compared to several other assets. This income – distributed every six months as coupon payments – is fixed. After settlement of maturities, tenders and demand bonds, the high yields market usually returns from 18% to 22% of its value each year in cash. Together with these payments, bonds with high profitability also have a known end value that investors can count on. As long as the issuer does not go bankrupt, investors recover the money when the bond is subject to redemption. All this helps to eliminate the effect of higher volatility of share prices and provide better protection against price drops. The average profits from the calendar year for the S & P 500 index and the Barclays High-Yield index in 1998-2018 amounted to 8.2% and 7.4% respectively. However, the average level of price volatility in this period amounted to 11.0%, which is almost twice as much as 5.7% in the case of bonds.
The use of wider spreads
A more typical approach to mitigating price volatility is the reallocation of assets to more stable and secure areas, such as investment grade bonds and even cash. However, this may mean the need to incur a significant opportunity cost, especially when high-yield spreads expand. When looking at the 12-month cumulative rate of return between 1994 – the first year in which Barclays provided data on spreads adjusted for options – and 2018, it can be concluded that yields on high-yield bonds exceeded rates of return on investment in equities. situation when credit spreads were large. How big should the spread be to justify investing in high-yield bonds as a replacement for equity exposures? In our opinion, it may be helpful to establish a decision-making rule. We conducted a simulation in which we set 525 basis points as the spread threshold – if the average spreads have moved above this level for the next two months, we sold the shares and bought high income bonds. In fact, investors would probably make an overestimation moving, for example, in the corridor from 20% of bonds and 80% of shares to 20% of shares and 80% of bonds.
An investor who invests $ 10,000 in the S & P 500 on January 1, 1994, and stays on this approach for the next 25 years, would only make 10 transactions – the last of which would be the sale of S & P 500 shares and the purchase of high-yield bonds in October 2016. The chart shows how a balanced portfolio would be shaped in relation to the respective indices. Hypothetical refunds assume that assets have been fully invested throughout the period and do not include transaction costs or taxes.
The results so far do not guarantee future results. It can not be guaranteed that the actual portfolio based on the hypothetical portfolio underlying the above illustration can be created or, if it arises, it will achieve the results suggested above. The results presented above are not based on the historical results of any investment portfolio. For the purposes of this hypothetical scenario, 525 bp. credit spread is the approximate long-term average. Spreads with high profitability are represented by credit spreads adjusted by the option for Bloomberg Bardays US Corporate High Yield *.
Rebalanced Portfolio performs tactical reallocation of funds within the established rule. Efficiency is based on spread levels and return rates. Returns do not include transaction fees, expenses or taxes.
Balanced portfolio: the investor started the period (January 1.1994) by investing in S & P 500 for the next nine years, after which: he sold S & P and bought high profitability on September 1, 1998; sold high profitability and bought S & P on March 1, 1999; sold S & P and bought high profitability on May 1, 2000; sold high profitability and bought S & P on October 1, 2003; he sold S & P and bought high profitability on January 1, 2008: he sold high profitability and bought S & P on March 1, 2011; sold S & P and bought high profitability on August 1, 2011; sold high profitability and bought S & P on February 1, 2013; sold to S & P and bought high profitability on October 1, 2015.
This illustration is not intended to provide a complete analysis of any variables that could affect a given portfolio
Fast loss recovery
With the increase in spreads, the potential to generate income from high-yield bonds increases, and investors can reinvest their income using the growing profitability. If the spreads continue to rise in 2019, causing price drops, investors may cover losses from equity investment in bond yields. For example, in the high-yield bond market, in the last 20 years, 10 losses were recorded in relation to the peak value above 5%. On average, investors regained their losses in the first nine revaluations on the bond market in less than six months – and sometimes even in two months (the market has already begun to recover some of the losses incurred during the 5.4% decline at the end of 2018). Of course, it is still very important to choose the exhibition exactly. The credit cycle is probably in the last phase, and insolvency rates are likely to increase this year.
It is not the most important in which order the equity and high income bond markets move relative to each other. The general conclusion is that adding high yield debt to the equity portfolio, when spreads are large, can reduce portfolio volatility without sacrificing too much return potential. This is of particular importance in the face of increasing volatility of market prices.
In the next article, we will take a closer look at the strategies that offer asymmetric returns.
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The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all RCieSolution management teams. Are subject to revision over time.