By Adam Schrier, CFA, FRM, Director, Product Management, New York Life Investments
In the past, we have argued against market timing and have made the case for high yield as a strategic allocation. While this belief still holds true, it is also true that low probability occurrences may present rare opportunities. Recently, high yield spreads surpassed 1000 bps which is double the 20-year median, as shown in Figure 1. Since 2000, month end spreads have been wider than 1000 bps only 5% of the time, and 850 bps 9% of the time.
The current market environment is marked by unprecedented volatility and an uncertainty that goes beyond financial markets, making market judgements extremely difficult. We will demonstrate historical investment outcomes given spread levels to provide context on the opportunity. However, it is important to not make investment decisions solely based upon spread levels, but given current levels, US high yield may warrant consideration.
Figure 1: Spreads have been wider than 500 bps 50% of the time and 1000 bps 5% of the time
Source: ICE Indices, 12/31/1999 – 2/29/2020. Past performance does not guarantee future results. An investment cannot be made directly into an index.
US high yield is a resilient asset class and even just a moderate holding period (2-3 years) has led to favorable investment results as shown in Figure 2. For example, investing when spreads were greater than the median has led to positive returns after 3 years 100% of the time. Investing below the median has led to 3-year positive returns 91% of the time. When spreads have been wider than 850 bps, 100% of returns were positive after 2 years. The median cumulative return subsequent to spreads reaching 1000 bps has been 44%, 63%, and 71% after, 1,2, and 3 years respectively. Summing this up, wider spreads and longer time horizons have resulted in attractive returns for the high yield market.
Figure 2: Wider spreads and longer holding periods have led to double digit returns
Source: ICE Indices, Morningstar, 12/31/1999 – 2/29/2020. Returns shown are cumulative. Past performance does not guarantee future results. An investment cannot be made directly into an index.
These double-digit returns are more reminiscent of the stock market than what many would expect from a bond portfolio. In Figure 3, we compare the high yield and stock markets during periods of spread tightening. Before we get to that, what is immediately apparent is that once spreads widen, they peak and subsequently tighten back up rather quickly –they don’t remain range bound at elevated levels for prolonged amounts of time. This is the explanation for the outsized returns – spread tightening can add significant capital appreciation to high yield coupons. So, to get a sense of what the opportunity is from spread tightening – we look at historical returns versus equities during those periods.
In tightening periods prior to and including the financial crisis, high yield outperformed stocks – in the case of the crisis, the relative outperformance was a staggering 4500 bps. In the recent expansion, stocks did outperform, but these periods were marked by less dramatic spread peaks as well as longer, more shallow tightening periods. Greater absolute spread levels and sharper spread declines have favored bonds relative to stocks.
In keeping with the theme of sharpness of spread tightening, in Figure 4, we compared high yield performance to stocks within the framework of spread moves – not just tightening, but also widening. This confirmed the earlier observation that sharper tightening led to high yield outperformance. Similarly, sharper moves in the other direction, spread widening, also led to high yield outperformance, albeit in the form of less drawdown. The greater the spread move – tighter or wider, the better high yield performed relative to stocks. In one year periods in which the ending spread level was within 200 bps of the beginning level, the median return of stocks was greater than that of high yield bonds.
Figure 4: High yield has outperformed stocks amid heightened spread volatility
Source: ICE Indices, Morningstar, 12/31/1999 – 2/29/2020 High yield represented by the ICE BofA US High Yield Index. Stocks represented by the S&P 500 Index. Past performance does not guarantee future results. An investment cannot be made directly into an index.
Given this unprecedented environment abound with uncertainty there are no obvious answers. When looking at high yield spreads and returns from a historical standpoint, there are patterns that emerge. Of course, the source of that variation differs across time periods and each crisis had different underpinnings. Statistically speaking, the median spread of the high yield market is 500 bps, and spreads have been between 400 bps and 700 bps about half of the time. Month end spreads have surpassed 850 bps and 1000 bps only 9% and 5% of the time respectively. We now find ourselves in that upper tail – for the first time since the financial crisis. The numbers show these levels have not lasted for extended periods of time, but have presented extraordinary return potential. Therefore, there is a window of opportunity in the high yield market which some investors may wish to explore with their advisors.
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are
also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner, or that negative perception of the issuer’s ability to make such payments may cause the price of that bond to decline. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
ICE BofAML U.S. High Yield Index tracks the performance of U.S. dollar-denominated below investment grade corporate debt publicly issued in the U.S. domestic market.
“New York Life Investments” is both a service mark, and the common trade name, of the investment advisors affiliated with New York Life Insurance Company. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.