From pension funds that invest in 100-year bonds to individuals who focus on earning monthly income, different types of investors have a wide range of time horizons. This blog discusses the prospect of investing in a high-yield bond index from both a short-term and long-term perspective. The idea of investing in high-yield bonds has become more mainstream, especially with the rise of multiple high-yield bond exchange traded funds (ETFs). These ETFs mitigate idiosyncratic (i.e. issuer-specific) risk by providing investors with low-cost exposure to well-diversified baskets of high-yield bonds. For illustrative purposes, this blog examines the Bloomberg Barclays US Corporate High Yield Total Return Index (High-Yield Index). Deutsche Asset Management’s forecasts imply that there is a positive short-term outlook for investing in the High-Yield Index, and in the long-term, investors who are concerned about lofty asset valuations and impending volatility may take comfort in the resiliency that the High-Yield Index exhibited through the worst financial crisis in recent memory.
What can investors who have a short-term (i.e. one year or less) view expect to earn from high-yield bonds today? To answer this question we need to discuss our expectations for some of the main factors that affect bond returns, namely: roll-down return, carry, and price return due to changes in interest rates and spreads.
Roll-down return characterizes the return that investors receive as bonds age and “roll” along the yield curve. To minimize complexity, we will not quantify roll-down return but instead note that it is positive in today’s upward-sloping yield curve environment.
Carry is the next component of return. For simplicity, we use yield to worst (YTW) as a proxy for carry on the High-Yield Index. The approximate carry that investors should expect to earn on the High-Yield Index is its current YTW of about 6.0%.
Price return is affected by duration and the path that interest rates and spreads take. The High-Yield Index has an option-adjusted duration of about 4.0, which means that for a 1% increase (decrease) in yield, price is expected to decrease (increase) by 4.0%. Deutsche Asset Management’s next twelve month forecasts (as of November 2017) imply that interest rates and spreads will deviate from their current levels. The table below summarizes our view:
Deutsche Asset Management’s forecasts imply about 39 basis points (bps) of tightening spreads and 35 bps of rising interest rates at the 4.0 year maturity (which matches the duration of the High-Yield Index). Tightening spreads and rising interest rates have an opposite effect on bond prices, and in this case their effects nearly cancel. Taking into account the duration of the High-Yield Index, price movements should have a small effect of about 0.2% on index returns.
Summing our estimates for carry and price return, our view is that investors could potentially expect to earn about 6.2% (i.e. 6.0% + 0.2% = 6.2%) on high-yield bonds over the next twelve months, and this estimate does not account for positive roll-down return that investors should also receive. Therefore, in today’s low rate environment, high-yield bonds may still be attractive for yield-seeking investors.
In the long-term, the focus shifts to risk-adjusted return, as near-term price fluctuations due to volatility in spreads and rates become less important. Consequently, the decision on whether to invest in the High-Yield Index is best influenced by examining its historical performance.
According to a Deutsche Bank default study from April 2016, during the financial crisis the maximum default rate of high-yield credits did not exceed 14%. Commensurately, high-yield bond indices declined by no more than 33% before they began to recover. How did these declines affect long-term investors who bought high-yield bond ETFs prior to the financial crisis? To get a sense for the answer to this question we can look at the total return of the High-Yield Index and compare it to the total return of the stock market over a ten year time frame that includes the financial crisis (i.e. August 2007 to August 2017).
Over this period, it appears that high-yield bonds weathered the crisis much better than equities. Depending on the exact time frame you look at, the total return on the S&P 500 is just beginning to catch up to the total return of the High-Yield Index, almost nine years after markets bottomed in the crisis. Another notable observation is that the total return of the S&P 500 recovered to pre-crisis levels in about 9 months (indicated by the blue arrow in the exhibit below), whereas the total return of the S&P 500 recovered in about 27 months (indicated by the gold arrow below using the same start date for comparison). In other words, it took three times longer for the equity index to make up for large losses in the financial crisis than for the High-Yield Index to do so. One explanation for this could be that the High-Yield Index’s high level of current income, relative to that of equity indices, greatly magnified the power of reinvesting cash flows at ultra-low prices during the financial crisis.
In addition, in the years that followed the crisis, the High-Yield Index not only exhibited higher returns but also exhibited lower volatility than the S&P 500. More details on this observation can be found in one of our previous Xpert Spotlight publications.
Ultimately, investing in the High-Yield Index may be an interesting option to consider for a long-term investor seeking to boost current income while gaining a strategic exposure to an asset class that better diversifies a portfolio of equities and lower-yielding bonds. Investors concerned with a future downturn should be relieved to observe how well and how rapidly the High-Yield Index rebounded after the financial crisis (though past performance is no guarantee of future results).
Diversification may not necessarily ensure a profit or protect against a loss.