We closed out April 2020 with the lowest yield in the history of the Bloomberg Barclays US Aggregate Index (Barclays AGG) at 1.31%. This low yield for investment grade bonds was due mainly to a surge in demand for safe assets in the face of a very uncertain economic backdrop (driving prices up, and yields down). At the same time, though, yields for the high yield sector (representing bonds rated below investment grade) rose significantly to levels that historically have provided investors with attractive subsequent returns. We believe investors should consider adding some high yield exposure to their bond portfolios given these historically attractive relative yields.
High Yield Credit Spreads Point to Higher Returns
In March the Bloomberg Barclays U.S. Corporate High Yield Bond Index (Barclays HY Index) rose significantly as did the credit spread (the credit spread is the additional yield over a duration equivalent Treasury bond). At that time we performed a historical study that measured subsequent three year total returns when credit spreads were over 900 basis points (bps). Credit spreads above 900 bps historically was a rare occurrence and proved to be a good entry point for longer term investors. Using daily data back to 1994 we found that less than 6% of the daily observations had a yield spread over 900 bps. For each of these observations, on average, the annualized total return over the next three years was an average of 19%. The worst one of those observations saw a subsequent three year annualized total return of 10%. Why look at subsequent three years? We believe that if the time horizon is any shorter one shouldn’t be buying such a volatile asset class.
Bloomberg Barclays U.S. High Yield Index
Source: Bloomberg
Did the Fed Remove the Punchbowl?
In April high yield credit spreads narrowed after the Federal Reserve said it would buy high yield ETFs and fallen angels (investment grade rated bonds downgraded to junk). The credit spread for the Barclays HY Index fell back below 900 basis points. Given these lower spreads we decided to revisit our analysis of historical spreads and subsequent returns. One thing about this analysis was that it was based on absolute returns. Given that high yield securities are typically used to augment an overall fixed income allocation we decided to adjust the historical analysis to compare returns of Barclays HY Index with that of the Barclays Agg – a standard measure for fixed income returns. We went back to the daily data series to look at credit spreads and subsequent relative three year performance.
Adding High Yield to Fixed Income: A Somewhat Mixed Outcome
As a baseline we first looked at the full history of annualized relative total returns between the Barclays HY Index and the Barclays Agg using daily observations. Historically 26% of the time the Barclays HY index underperformed the Barclays Agg by an average of 5 percentage points annualized. Still, the majority of the time an allocation to high yield added value.
Relative Performance
High Yield versus Investment Grade
Source: Bloomberg
The chart depicts the distribution of historical relative 3 year returns between the Barclays HY Index and the Barclays Agg. In 26% of the observations the Barclays HY Index underperformed the Barclays Agg.
Improving the Odds
Can we improve on those odds? The credit spread is a type of valuation measure. If we sort the historical data by credit spread one finds a very strong relationship between the credit spread and likelihood of the Barclays HY Index outperforming the Barclays Agg. Historically we find that as credit spreads increase so do the odds of subsequent relative outperformance as depicted in the below chart. At the end of April the high yield credit spread was 744 basis points.
Percent of Observations With Subsequent Outperformance
Source: Bloomberg
The chart depicts the percent of historical observations when the Barclays HY Index subsequently outperformed the Barclays Agg over the following 3 years based on the starting Barclays HY Index credit spread. For example, for those observations when the Barclays HY Index had a credit spread between 200 and 299 basis points, the Barclays HY Index saw subsequent outperformance 27% of the time.
The Ratings Mix
Another interesting factor to consider relates to the composition of the Barclays HY Index today. BB rated bonds are the highest rated in the index and as of April represented the highest proportion of the index and for the first time made up over 50% of the index. This ratings distribution is just the opposite for the investment grade corporate universe where the lowest rated bonds make up the highest proportion. The rating composition can have an impact on the overall spread for the index. Given a larger weight in higher quality bonds, the current spread is likely to be understated in a historical context. The following chart looks at the current spread distribution relative to where the index was entering into the last two recessions.
Index Rating Distribution
Source: Bloomberg
The chart depicts the distribution of the Barclays HY Index by credit rating prior to the last two recessions and as of April 2020. BB rated bonds are the highest rated within the high yield sector, followed by B rated bonds and CCC rated bonds are the lowest rated.
Conclusion and Risk Considerations
While we expect the Barclays AGG to continue to serve as a ballast to equity risk in a balanced portfolio, the all-time low yield points toward a sparse return outlook. We believe that investors should be paid for taking risk. Today the high yield sector is providing historically healthy compensation in the form of the credit spread for taking on this risk. And the overall index credit spread does not consider the current higher rating distribution within the index. As this COVID crisis eases and we return to some form of normalcy, these spreads and relatively high yields will likely go away. We do not believe this opportunity to pick up yield will last indefinitely. But we must also point to some potential caveats. While history can act as a guide there is no guarantee that it will repeat in the same fashion. The nature of the current economic downturn is unique. We would also note that while the Federal Reserve can help restore liquidity to the markets it cannot address solvency issues. As such the Fed’s actions do not reduce bankruptcy risk. We are seeing more bankruptcies and expect the number to continue to increase. Considering these factors we suggest taking a more selective approach to high yield. Consider turning to an active manager with flexibility, deep research capabilities, and a strong risk management discipline to help source higher levels of income.
The information provided represents Touchstone’s views and observations regarding past and current market conditions and investor behaviors. The information and statements provided here are believed to be true and accurate. There can be no assurance however that the beliefs expressed herein will be consistent with future market conditions and investor behaviors.
Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index comprised of U.S. investment grade, fixed rate bond market securities, including government, government agency, corporate and mortgage-backed securities between one and 10 years.
Bloomberg Barclays U.S. Corporate High Yield Bond Index 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.
The indexes mentioned are unmanaged statistical composites of stock market or bond market performance. Investing in an index is not possible. Unmanaged index returns do not reflect any fees, expenses or sales charges.
A Word About Risk
Fixed-income securities can lose their value as interest rates rise and are subject to credit risk which is the risk of deterioration in the financial condition of an issuer and/or general economic conditions that can cause the issuer to not make timely payments of principal and interest also causing the securities to decline in value and an investor can lose principal. When interest rates rise, the price of debt securities generally falls. Longer term securities are generally more volatile. Investment grade debt securities may be downgraded by a Nationally Recognized Statistical Rating Organization (NRSRO) to below investment grade status. Non-investment grade debt securities which are considered speculative with respect to the issuers’ ability to make timely payments of interest and principal, may lack liquidity and can have more frequent and larger price changes than other debt securities. Equities are subject to market volatility and loss. Preferred stocks are relegated below bonds for payment should the issuer be liquidated. The fixed dividend may be less attractive in a rising interest rate market. Convertible securities are subject to the risks of both debt securities and equity securities.
Past performance is no guarantee of future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than performance data given. Active Share is not a performance measurement. A high level of Active Share does not assure outperformance of a fund relative to its benchmark index. Investing involves risk, including the possible loss of principal and fluctuation of value. Please visit touchstoneinvestments.com for performance information current to the most recent month-end.
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