It’s hard to keep a good junk bond down
Take the best teams and athletes across all sports, and sooner or later, at some point, they lose. The best hitter strikes out, the most accurate shooter misses an open 3-pointer, and the most sure-handed wide receiver drops a perfect pass in the end zone. We don’t always judge them on their mistakes, but rather on what they do afterwards. More often than not, the all-time greats persevere and don’t let those down moments define them. Similarly, in investing, it is likely that most asset classes will lose money at some point. It is important to not only look at their losses, but how they perform afterwards as well.
Before 2018, high yield bonds have had five down years since 1980, according to JP Morgan. Each one of those down years was followed by a year in which high yield generated a positive return, often times to a much greater extent than the preceding year’s loss. Case in point, high yield was down 6.4% in 1990. In 1991, high yield more than made up for that loss, as the asset class returned 43.8%. The financial crisis led to the worst year in high yield history – the asset class declined 26.6% in 2008. However, in 2009, investors were rewarded with the best calendar year on record – a total return of 58.2%. In more recent memory, the energy crisis of 2015 beat up high yield a bit, only to bounce back almost 19% in 2016, as seen below in Figure 1.
Figure 1: Prior to 2018, High Yield was Down 5 Times in 38 Years
Source: JP Morgan 12/31/18. Past performance is no guarantee of future results, which will vary.
Why Has High Yield Historically Recovered So Swiftly?
For one thing, bonds mature at par, so assuming a bond does not default, the company will pay back investors back the full par value. Historically, most companies have not defaulted, as evidenced by a 3.5% long-term default rate according to JP Morgan. Market participants tend to quote the 12-month default rate which at year end was 1.8%, or slightly more than half of the long term average.
Even when companies don’t default, their perceived or actual credit risk may increase, which drives spreads wider and bond prices lower. What is apparent in Figure 2 is that when spreads have widened in the past, they seemingly widened fairly rapidly, but didn’t stay wide for long. The market recovered nearly as fast, and upon recovery, spreads remained relatively range bound for some time. We highlighted four economic events over the last 15 years, which caused the cumulative return of the ICE BofAML US High Yield Index to dip – in the case of the financial crisis – a severe dip, but in each case, the index returned to its upward trajectory fairly quickly. The thing about high yield is that investors can earn a positive return without spreads tightening. If spreads remain range bound, an investor can earn a relatively attractive rate of return for the period, due to the high current income generated by coupons. In fact, high yield generated a cumulative return of 201% from the end of 2008 through November 2018. Of that 201%, only 35% of the gain in the JP Morgan Domestic High Yield Bond Index is attributed to price appreciation, leaving 166% of the return due to coupon income.
Figure 2: High Yield Bonds Recover Swiftly and Sharply After Spreads Widen
Source: ICE Bank of America Merrill Lynch, Morningstar 12/31/18. High Yield represented by the ICE BofAML High Yield Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Let’s dig a little deeper into high yield’s performance during the financial crisis. In Figure 3 we can see that high yield declined sharply from the end of May 2008 through the end of November of the same year. During that 6-month period, the index lost 32.5% of its value. If an investor unwittingly bought high yield at the worst possible time, they would have broken even a little over a year later in the summer of 2009. The worst performing period in its history, and it would only take about a year for an investor to be made whole. Furthermore, from the bottom of the market in November 2008, they would have earned 205% in the following ten years and one month through the end of 2018.
Figure 3: High Yield Broke Even After 14 Months During the Financial Crisis
Source: Morningstar 12/31/2018. High Yield represented by the ICE BAML US High Yield Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
High yield, like most risk assets, got caught up in the volatility of 2018 and unfortunately ended the year in the red. The asset class saw outflows, as retail investors became more risk averse. What the asset class hasn’t seen, in our opinion, is a deterioration of fundamentals and an expectation of an elevated level of defaults. Leverage in high yield issuers has actually trended downward while new issuance quality has trended upward. While we can’t use past performance to predict the future, high yield bonds have certainly persevered through adversity in the past, in large part because of their big coupons. With a yield of approximately 7.5%, this may be an attractive entry point for those seeking unleveraged, stable income. For investors who are fairly constructive on the economy, it may be the right time to have a discussion regarding high yield.
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.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
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.
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.
The ICE BofAML U.S. High Yield Index tracks the performance of below investment grade, but not in default, US dollar denominated corporate bonds publicly issued in the US domestic market, and includes issues with a credit rating of BBB or below, as rated by Moody’s and S&P.
The 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.
The S&P 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the
High yield corporate bonds are represented by the Bloomberg Barclays High Yield Corporate Index, which measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, New York, New York 10010, provides investment advisory products and services. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.