A Window of Opportunity in High Yield

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.

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.

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.

Figure 3: High yield returns versus stocks when spreads tightenSource: 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.

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.

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.