By Adam Schrier, Director, Product Management for New York Life Investments
In our daily lives, price is the value paid for goods and services, which we typically consume without the expectation of earning a profit. At a restaurant, after paying the bill, we are left with nothing but a memory and maybe a doggie bag. Yet, in the investment world, this is not the case. Typically, an investor has an expectation that the value of his/her asset will increase. If an investor buys a stock at $20, they may expect it to be worth $25 in the future. Following that logic, if the same investor pays $105 for a bond, they wouldn’t want to only receive $100 back in the future – or would they? Does price explain the value of bonds?
The basics: What is a premium bond?
Par ($100) represents the face value of a bond received at maturity. Bonds that trade above par are defined as “premium” bonds and bonds that trade below par are “discount” bonds. However, just because a bond is purchased at a premium does not make it a losing proposition. In fact, these bonds may still be considered cheap since the relative value of a bond is actually determined by assessing the bond’s yield, which is a function of prevailing interest rates, credit spreads, coupon and stated maturity.
Bond pricing is more a mathematic equation than an investment indicator; price merely balances the coupon and the yield. For example, in Figure 1, we look at three bonds with 5 years left to maturity and a 4% yield. The bond with a 5% coupon trades at a premium to balance out the 4% yield agreed upon by the buyer and seller. Conversely, the bond with the 3% coupon trades at a discount to make up for the additional 1% in required yield. In other words, if you only look at price and don’t take coupon or, more importantly, yield into account, you’re missing a valuable piece of the story. In addition, as Figure 1 also shows, premium bonds offer lower duration and therefore less interest rate risk. By only considering price, an investor may be viewing value through an imperfect lens and miss out on an attractive opportunity.
Figure 1: Price balances the yield and coupon
This is a hypothetical illustration.
In high yield, do prices predict returns?
Bond math aside, what does this all mean empirically? To determine if there are any noteworthy observations, we examined the price/return relationship in the high yield market. In Figure 2, we look back 20 years and calculate the median 18-month and 3- year forward returns for high yield and core bonds segmented by price of the high yield index. Here is what we found:
- In both 18-month and 3-year rolling periods, prices below 97, and below 90 in particular, allowed for outsized returns.
- Over 18-month holding periods, high yield still generated 320 bps in excess of the Bloomberg Barclays Aggregate Bond Index when starting prices were greater than 103.
- For 3-year periods, the results were less linear. Periods marked by premium bonds priced below 103 outperformed periods that began with a discount price between 97-100, on both an absolute basis and relative to core bonds.
- 3-year holding periods with a starting price greater than 103 had similar outperformance relative to core bonds as the 97-100 discount segment.
Figure 2: Returns segmented by price
Source: Morningstar and ICE BofAML, as of 12/31/19; 20-year period 12/31/99-12/31/19.1 Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Given these observations, there are a number of inferences that can be made when it comes to price and value in the high yield market.
- There are no obvious signals based on price alone to shy away from entering or to make a decision to exit the asset class.
- Low prices have historically provided the opportunity for exceptional returns. However, during periods of declining prices, there has tended to be a risk-off sentiment in the market and therefore outflows from high yield, despite what historical data tells us about returns given low prices.
- In the shorter holding period, returns were inversely related to price. However high yield has provided meaningful outperformance relative to the broader fixed income market regardless of the price. Whether this translates into value will be based on other factors.
- The relationship between price and returns is even weaker over the still moderate holding period of 3 years. Investing when bonds were at a premium up to 103 netted 1,000 bps of cumulative outperformance over core bonds.
Are spreads a better indicator?
Arguably a more widely tracked metric and certainly a more important one, is spread. In Figure 3, we take the same 20-year period and overlay rolling 3-year forward returns with starting spread, instead of price. What immediately jumps out is that when spreads widen, the opportunity for outsized returns presented itself. Once spreads widened, they peaked and subsequently tightened back up rather quickly – they don’t appear to have remained range bound at elevated levels for any significant amount of time. This propensity for spreads to tighten makes a strong argument for a strategic allocation to high yield.
While there appears to be some relationship between spreads and returns, most 3-year periods delivered attractive returns regardless of beginning spread level. Therefore, spreads may provide greater insight into market sentiment as compared to price, but like price, market spread levels alone do not provide enough context to unilaterally influence portfolio allocation decisions. The interesting thing about high yield is that if spreads, or prices for that matter, end the year in the same place they started – the investor would still earn a positive return – the coupon.
Figure 3: Spreads and rolling 3-year forward returns
Morningstar and ICE Indices, as of 12/31/19; 20-year period 12/31/99-12/31/19.2 Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
There are no hard and fast rules when it comes to investing in high yield bonds, but it is clear that a decision requires a myriad of data points. Of these, price has limited practical application to constructing a fixed income portfolio. Not only may an investor be missing out if they look at price alone, but there are more important fundamental and technical drivers of investment outcomes. Similarly, it is worth looking at investment options beyond an isolated time series. For example, the credit quality of the high yield market has increased over time – the par value of the lowest rated portion of the market, CCCs, has declined from over 30% to under 15% since the financial crisis. This changing landscape of high yield needs to be considered in today’s investment decisions. As such, investors may benefit more from high yield by taking a long-term approach with a disciplined manager rather than looking for short term signals based on market characteristics.
- High Yield is represented by the ICE BofAML U.S. High Yield Index; Core Bonds is represented by the Bloomberg Barclays Aggregate Bond Index.
- High Yield is represented by the ICE BofAML U.S. High Yield Index; Core Bonds is represented by the Bloomberg Barclays Aggregate Bond Index; Spread is represented by ICE BofAML U.S. High Yield OAS Spread.
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.
Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.
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 certain investment advisors affiliated with New York Life Insurance Company. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.