Is High Yield Worth The Risk?

Posted on July 19, 2018 by Gemmer Asset

image_printPrintable Version

Given where credit spreads are (see below) and the fact that we’re late in the economic cycle, it’s worth asking the question: is taking high yield credit risk worth it?

 

1

 

If you look at yield alone, the roughly 6% you’re getting from junk bonds is certainly appealing, but we’d argue that there are three main risks to having this type of credit exposure at this stage in the cycle.

 

High Yield Spreads Widen Before A Recession Begins

 

By most measures, the US is in the later innings of the second longest recovery in history, and one of the key aspects to assessing high yield (or any asset class for that matter) is figuring out how it has performed in similar periods. Jeff Gundlach at DoubleLine has done some good work on this. Below is a chart showing how high yield spreads have behaved in the trading days leading up to recessions. What Gundlach is trying to show is that high yield spreads widen significantly before a recession, and in the prior two recessions the widening began 6 months to a year before the start.

 

2

 

Current spreads haven’t begun to widen (red & black lines), but it doesn’t hurt to be early on this trade– you don’t want to be looking for a life raft at the same time as everyone else.

 

Equity And High Yield Returns Are Highly Correlated

 

One of the main benefits to holding bonds in a diversified portfolio is that they can offer protection in the event of an equity down market. High yield, not so much. Here are the correlations going back 20 years of both high yield and high quality bonds versus the S&P 500.

 

3

 

High quality intermediate bonds (the Aggregate Index) offer slightly negative correlation to the S&P. High quality short-term bonds are even more negatively correlated.

 

The risk we’re trying to describe here is that just because they’re bonds, doesn’t mean they’ll offer protection from equity declines. To see how these correlations have manifested themselves in actual return numbers, take a look at the below table.

 

4

 

Yield Does Not Equal Total Return

 

Let’s say you have index exposure to the high yield space. Assume that basket of bonds is trading at par ($100) and you’re getting a yield of about 5.8% (which is the SEC yield on the iShares high yield corporate ETF – HYG). If you take into account the current speculative grade default rate of 3% in the U.S., its easy to approximate your total return:

 

5

 

2.8% is nowhere near as attractive as 5.8%, especially given that the 2 year Treasury is at 2.6%. Its always good to remember that yield doesn’t equal total return. For high yield to beat traditional bonds on a total return basis, spreads need to tighten from their already compressed levels. While this could happen, we wouldn’t bet on it at this point in the cycle.

 

OK, So What’s A Good Alternative?

 

So you trim or eliminate high yield. What do you do with that money? We pointed out the negative correlation that short-term bonds have with stocks. What do you have to give up in yield to get that benefit? Combine the upward trend in short-term rates with our total return equation from above and the answer is: not much.

 

6

 

The increase in short-term relative to long-term rates has done two things: 1) flattened the curve and 2) made short-term instruments more attractive. For example, the Vanguard Prime Money Market Fund (VMMXX) has an SEC yield of 2.05%, and Schwab’s Value Advantage Money Market Fund (which has a much lower minimum) is yielding 1.9%. If you compare these yields with the total return of high yield from our equation above, its almost a no brainer. Why take the volatility of the high yield market when you can collect 2% in the highest quality short-duration safety of a money market fund. Bank CDs, which have a slightly higher yield depending on duration, would also make sense in this environment, but they have two main drawbacks relative to money market funds. 1) You’re locked in for the duration – in the event you need the cash, you’ll have to take a sizeable haircut to get out and 2) to the extent you’re locked in, the CD rate wont float as the Fed continues to hike rates, whereas money market funds will adjust their yields accordingly.

 

All this isn’t to say you should move your entire credit allocation to cash. The point we’re trying to get across is that the risk/reward tradeoff in the high yield space is getting more challenging, and that cash as an alternative can make some real sense in the context of a well-diversified bond portfolio.

 

 

MM Email Sig

 

 

Published by Gemmer Asset Management LLC The material presented (including all charts, graphs and statistics) is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. The material is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objective, financial situations, or needs of individual clients. Clients should consider whether any advice or recommendation in this material is suitable for their particular circumstances and, if appropriate, see professional advice, including tax advice. The price and value of investments referred to in this material and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or prices of, or income derive from, certain investments. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior written consent of Gemmer Asset Management LLC (GAM). Any mutual fund performance presented in this material are used to illustrate opportunities within a diversified portfolio and do not represent the only mutual funds used in actual client portfolios. Any allocation models or statistics in this material are subject to change. GAM may change the funds utilized and/or the percentage weightings due to various circumstances. Please contact GAM, your advisor or financial representative for current inflation on allocation, account minimums and fees. Any major market indexes that are presented are unmanaged indexes or index-based mutual funds commonly used to measure the performance of the US and global stock/bond markets. These indexes have not necessarily been selected to represent an appropriate benchmark for the investment or model portfolio performance, but rather is disclosed to allow for comparison to that of well known, widely recognized indexes. The volatility of all indexes may be materially different from that of client portfolios. This material is presented for informational purposes. We maintain a list of all recommendations made in our allocation models for at least the previous 12 months. If you would like a complete listing of previous and current recommendations, please contact our office.

Categories:

Bookmark and Share