One Investor’s Junk (Bond) Is Another’s Treasure
“Should I invest in junk bonds?” may not be the appropriate question investors need to be asking their advisors. For many, high-yield bonds have a place as a strategic allocation in a fixed-income portfolio, due to the relatively high income the asset class has provided, as well as the opportunity for capital appreciation and low correlation to other fixed-income investments. Therefore, the more relevant question is, “Which high-yield bond strategy is optimal, given my risk tolerance and investment objectives?”
Understanding Interest-Rate Risk vs. Credit Risk
In order to understand the different ways to invest in high yield, we first need to address the two main risks of fixed-income investing – interest-rate risk and credit risk. Interest-rate risk refers to the property of bonds in which their value decreases as interest rates rise. Credit risk is simply the likelihood that a bond issuer will not be able to meet its debt obligations.
With respect to high-yield bonds, credit risk tends to be the predominant risk, as the companies issuing these bonds are generally more levered than their investment-grade counterparts. In Duration: Not Debunked, Just Practically Applied, we discuss why credit-sensitive high yield has a relatively low sensitivity to interest rates vis-a-vis other fixed-income investments. While this is true as an overarching theme, there is some variation within high yield as far as sensitivities. High-yield investments don’t necessarily exist on a continuum with credit and rate risks on opposite sides, but rather, there are numerous permutations with more or less of these risks.
Figure 1: Credit Quality Breakdowns Vary across High-Yield Indices
Sources: ICE BofAML, S&P, as of 10/31/17. Chart created by NYLIM. High Yield Corporate Bonds are represented by the ICE BofAML US High Yield Constrained Index; Short Duration High Yield Bonds are represented by the ICE BofAML 1-5 Y BB-B Cash Pay HY Index; High Yield Low Volatility Bonds are represented by the S&P US High Yield Low Volatility Corporate Bond Index. Credit ratings agencies, such as Moody’s, Standard & Poor’s, and Fitch Ratings, have letter designations (such as AAA, B, CC) which represent the quality of a bond. Moody’s assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with WR and NR as withdrawn and not rated. Standard & Poor’s and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, and D.
The above figure demonstrates the credit quality of three high-yield benchmarks with varying degrees of interest-rate and credit risk. High-yield corporate bonds is the broad high-yield market, whereas short duration high yield is a subset of the overall market and is characterized by bonds with shorter maturities and a bit higher credit quality, as described in What Does Short Duration Mean for Credit-Sensitive High Yield. These categories of high yield are represented by the ICE BofAML US High Yield Constrained Index and the ICE BofAML 1-5 Y BB-B Cash Pay HY Index, respectively. The High Yield Low Volatility Bonds are represented by the S&P US High Yield Low Volatility Corporate Bond Index, which constructs the index by narrowing down a universe of high-yield bonds to the less risky credits using the duration times spread framework. For more information on this framework, please see the Index’s homepage.
Given that credit spreads are currently tight by historical standards, it is true that this allows some interest-rate risk to creep into the high-yield market. With less of a yield cushion, large interest-rate swings may impact high-yield bond prices. However, we still maintain that credit risk is the most salient driver of high-yield performance, and Figure 2 shows calendar-year performance of the three referenced indices versus the market’s option-adjusted spread (OAS), the excess yield over the risk-free rate. This is largely consistent with the credit breakdown of the indices – in years when spreads compressed, the broad market index was the outperformer, and when spreads widened, the high yield low volatility index held up best. Short duration high yield was usually somewhere in between. By increasing credit risk, an investor may earn a greater return relative to an investor who takes less risk. Therefore, depending on an investor’s risk appetite, he/she can allocate among the three indices to achieve the desired level of credit risk.
Figure 2: High Yield, Short Duration HY, and High Yield Low Vol Returns vs. Spreads
Sources: Morningstar, ICE BofAML, as of 10/31/17. Chart created by NYLIM. High Yield Corporate Bonds are represented by the ICE BofAML US High Yield Constrained Index; Short Duration High Yield Bonds are represented by the ICE BofAML 1-5 Y BB-B Cash Pay HY Index; High Yield Low Volatility Bonds are represented by the S&P US High Yield Low Volatility Corporate Bond Index. OAS is the option-adjusted spread. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Interest-rate sensitivity in the high-yield market is a bit more challenging to observe since longer-term performance is attributed to credit spreads and income, Therefore, this risk is best exhibited during short-term periods encompassing significant rate shocks. In Figure 3, we expand upon a JP Morgan analysis that tracks high yield performance of three-month periods in which the five-year Treasury spiked by 70 basis points (bps) or more. Omitted are periods prior to the availability of data for the high yield low volatility index and a period during the financial crisis in which spreads moved over 500 bps (making it difficult to draw meaningful conclusions regarding the rate move). The left-hand axis is the three-month returns for the periods ending on the stated dates. The right-hand axis plots the move in bps of the OAS of the JP Morgan HY Index, which is important, because by viewing periods with smaller spread movements, you can be more confident that the performance is mostly explained by the magnitude of the Treasury spike indicated on x-axis.
The three-month periods ending June 2004, December 2016, and December 2010 are the periods in which spreads tighten the least, and in July 2013, spreads actually widen to a small degree. In each of these periods, low volatility high yield underperforms the other two indices, suggesting it may be more susceptible to interest-rate moves, which is to be expected since its constituents are more similar to investment-grade bonds than the other two indices. However, given that it is still high yield, it retains the high-yield characteristic of resilience in the face of rising rates, as evidenced by its significant outperformance over the investment-grade credit index, which posted negative returns in each period examined.
Interestingly, in the majority of the three-month periods with rate spikes, high yield still earned positive returns, regardless of the high-yield category, further demonstrating that interest-rate risk is secondary to credit risk.
It is also worth noting in the two periods that the overall market was negative, short duration high yield performed the best, highlighting this investment’s versatility as a defensive play – whether rates or credit is the catalyst of that volatility.
Figure 3: High-Yield Categories, Investment-Grade Credit vs. Five-Year Treasury Spikes
Sources: Morningstar, JP Morgan, as of 10/31/17. Chart created by NYLIM. High Yield Corporate Bonds are represented by the ICE BofAML US High Yield Constrained Index; Short Duration High Yield Bonds are represented by the ICE BofAML 1-5 Y BB-B Cash Pay HY Index; High Yield Low Volatility Bonds are represented by the S&P US High Yield Low Volatility Corporate Bond Index; Investment Grade Corporate Bonds are represented by the Markit iBoxx USD Liquid Investment Grade Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
So, What Does This All Mean for High-Yield Investors?
Recall our original question about whether or not an investor should invest in high yield. The set of high yield asset class investment options has expanded, and as such, requires a more in-depth analysis than a mere perfunctory glance to determine suitability for an investor. Within the scope of our analysis, the overall high-yield index has the most credit risk, while the high yield low volatility index has the least. Short duration high yield may be the least exposed to interest-rate shocks, whereas high yield low volatility appears to be the most impacted.
As we stated earlier, high yield may represent a strategic allocation for many investors, due to the attractive income and potential for capital appreciation, as well as its diversification benefits. Therefore, it is prudent to perform the necessary due diligence on the available high yield offerings to ensure an investor makes the decision that best achieves the risk/return objectives of their overall portfolio.
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments 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 subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
This material is provided for educational purposes only and should not be construed as investment advice or an offer to sell or the solicitation of offers to buy any security. Opinions expressed herein are current opinions as of the date appearing in this material only.
All investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.
Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
Bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner. A bond’s prices are inversely affected by interest rates. The price will go up when interest rates fall and go down as interest rates rise.
High-yield securities carry higher risks and some of the Fund’s investments have speculative characteristics and present a greater risk of loss than higher-quality debt securities. These securities can also be subject to greater price volatility.
Credit ratings agencies, such as Moody’s, Standard & Poor’s, and Fitch Ratings, have letter designations (such as AAA, B, CC) which represent the quality of a bond. Moody’s assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with WR and NR as withdrawn and not rated.
Standard & Poor’s and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, and D.
High Yield Corporate Bonds are represented by the ICE BofAML US High Yield Constrained Index.
Short Duration High Yield Bonds are represented by the ICE BofAML 1-5 Y BB-B Cash Pay HY Index.
High Yield Low Volatility Bonds are represented by the S&P US High Yield Low Volatility Corporate Bond Index.
Investment Grade Corporate Bonds are represented by the Markit iBoxx USD Liquid Investment Grade Index.
Basis points (bps) refer to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
Interest-rate risk is the risk that an investment’s value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any other interest-rate relationship.
The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option.
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
The ICE BofAML BB-B U.S. High Yield Constrained Index contains all securities in the ICE BofAML U.S. High Yield Index rated BB+ through B- by S&P (or equivalent as rated by Moody’s or Fitch), but caps issuer exposure at 2%. Index constituents are capitalization-weighted, based on their current amount outstanding, provided the total allocation to an individual issuer does not exceed 2%.
ICE BofAML 1-5 Y BB-B Cash Pay HY Index tracks the performance of BB rated U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market with maturities of 1 to 5 years.
The S&P U.S. High Yield Low Volatility Corporate Bond Index is designed to measure the performance of U.S. high yield corporate bonds with potentially low volatility. The index is comprised of bonds from the S&P U.S. High Yield Corporate Bond Index and is a modified market value weighted index with a 3% cap on any single issuer.
The Markit iBoxx USD Liquid Investment Grade Index is designed to provide a balanced representation of the USD investment grade corporate market and to meet the investors demand for a USD denominated, highly liquid and representative investment grade corporate index.
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MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, New Jersey 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.