Playing Defense in High Yield
Almost a decade after the start of the Financial Crisis, the Fed is finally starting to make headway in trying to “normalize” interest rates. There’s a widely held view that the markets are in for at least two more bumps to the Federal Funds Rate in 2017, and maybe more. At the same time, the Trump “reflation” trade has helped push rates higher on the long end of the yield curve, too.
So, you would think that income-oriented investors can finally breathe a sigh of relief as the so-called “risk-free” rate of return inches up.
Income is still hard to come by, and that challenge is now compounded by the very real threat to principal, experienced in a rising rate environment. Suddenly, volatility matters.
For investors trying to thread that needle, high-yield bonds have proven attractive. These are fixed-income securities rated double-B and lower by Standard & Poor’s or Ba or below by Moody’s, and are currently trading to yield about 3.80% above 10-year Treasurys1, the usual benchmark.
Because of their leverage and economic sensitivity, high-yield bonds can be volatile. Contrary to investment-grade and government agency bonds, they have historically held up well in periods of strong economic growth and rising rates. Growth tends to make it easier for issuers to service their debts, while a higher coupon can provide an income cushion against a potential decline in the price of the bonds (especially when that income is reinvested at the lower price). In fact, high-yield returns are more closely correlated with small-cap stocks, as measured by the Russell 2000 Index (Source: Barclays via a story in Barron’s in October 2014), than with investment-grade corporate bonds, shown by the Merrill Lynch Corporate Bond Index.
Sources: IndexIQ and FactSet , as of 1/31/17.
But, not all high-yield bonds are created equal, and some are more volatile than others. Multiple factors can contribute to this: credit quality, industry sector, duration, and the strength of the economy, generally. A further complicating factor: investor demand for high-yield bonds has been up in recent years, which has helped compress credit spreads, another potential source of volatility.
While no asset class is immune, there are ways to position a portfolio – or a rules-based Exchange-Traded Fund (ETF) – within the market that can help manage that volatility (measured by standard deviation). One way is to invest in high-yield bonds thought to have less credit risk. This can be done using market-based information that combines a bond’s spread and duration into a measure called “Marginal Contribution to Risk” (MCR).
Higher credit spreads are generally associated with poorer credit quality and that, in turn, is correlated to more defaults and higher volatility. Longer-duration bonds tend to be more volatile, partly because an investor’s money is at risk for a longer period of time. MCR is designed to adjust for this. In particular, it seeks to exclude bonds with a high MCR (higher credit risk), which should result in lower exposure to defaults, muted drawdowns, and lower levels of volatility, according to our research.2
After a multi-decade period that saw interest rates mostly headed downward – including the extraordinarily low rates of the last few years – it looks like the trend is starting to reverse. For many investors, navigating through a time of rising rates is like wandering through a foreign country. In this journey, a high-yield bond investment that factors in both credit quality and duration into its rules-governing portfolio construction can offer a solution for those seeking to generate current income, while seeking to avoid at least some of the market’s volatility.
1. Bloomberg, as of 2-12-17. Represented by the BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread.
2. Bruno, Salvatore. “Fixed Income Factor Investing: Low Volatility High Yield,” IndexIQ, February 2017.
All investments are subject to market risk and will fluctuate in value. Alternative investments are speculative, entail substantial risk, and are not suitable for all clients. Alternative investments are intended for experienced and sophisticated investors who are willing to bear the high economic risks of the investment. Investments in absolute return strategies are not intended to outperform stocks and bonds during strong market rallies. Hedge funds and hedge fund of funds can be highly volatile, carry substantial fees, and involve complex tax structures. Investments in these types of funds involve a high degree of risk, including loss of entire capital. Treasurys are backed by the full faith and credit of the Federal government as to the timely payment of principal and interest.
The BofA Merrill Lynch Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. The BofA Merrill Lynch High U.S.Yield Master II OAS uses an index of bonds that are below investment grade (those rated BB or below).
Merrill Lynch Corporate Bond Index is an unmanaged index comprised of U.S. dollar-denominated, investment-grade corporate debt securities publicly issued in the U.S. domestic market, with at least a one-year remaining term to final maturity.
The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index. The Russell 2000 is by far the most common benchmark for mutual funds that identify themselves as “small cap.”
Correlation is a statistic that measures the degree to which two securities move in relation to each other.
Credit risk is the risk of loss of principal or loss of a financial reward, stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation.
Credit spread is the difference in yield between a U.S. Treasury bond and a debt security with the same maturity, but of lesser quality.
Drawdown is the peak-to-trough decline during a specific recorded period of an investment, fund, or commodity.
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.
Federal Funds Rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis.
Leverage is the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.
Marginal Contribution to Risk (MCR) measures the additional risk the bond contributes to the broad market. MCR is simply the difference between the duration times spread (DTS) of the bond and the DTS of a bond trading at the average market credit spread level. MCR serves as a useful estimation of a bond’s credit risk as the higher the MCR, the more implied credit risk the bond contributes to the overall portfolio. Bonds with positive MCR tend to add risk to the broader market, whereas bonds with negative MCR tend to reduce risk of the broader market. Low MCR bonds are bonds ranked 0-50% in the universe, and the high MCR bonds are ranked 51-100% in the universe.
Risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.
Standard deviation is a measure of the dispersion of a set of data from its mean.
Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. Longer-term bonds – the “long end” of the curve – are influenced to some extent by the outlook for Fed policy, but other factors play a role in moving long-term yields up or down. Foremost among these are the outlook for inflation, economic growth, supply-and-demand factors, and investors’ general attitude toward risk.
Standard and Poor’s BB rating is a bond rate, which is generally considered speculative in nature and not considered to be investment-grade bonds suited for people wishing to avoid the risk of losing their principal. Bonds rated BB provide a yield-to-maturity or yield-to-call rate that is well above bonds with higher ratings, especially those issued by the U.S. government, municipalities, and the largest global corporations.
Ba is a bond rating by Moody’s. It is subdivided (in decreasing order) into Ba1, Ba2, and Ba3. A Ba rating is equivalent to a BB rating by S&P. A Ba rating is the highest possible junk bond rating, meaning that a bond with this rating carries less risk than other junk bonds.
The information and opinions contained herein are for general information use only. IndexIQ does not guarantee their accuracy or completeness, nor does IndexIQ assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are as of the date of this report and are subject to change without notice. Past performance is no guarantee of future results.
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