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?
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.
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.
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.
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:
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.
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.
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