A high-yield lesson from history
Richard Ryan warns investors not to respond to apparently tight spreads in investment-grade bonds by simply stretching for the extra 260 basis points available from high yield
Institutional investors want yield. This search for just about any form of a decent income has led many to the high-yield bond market.
The headline yields available from high-yield bonds appear to justify taking more risk. A basket of European high-yield bonds now pay you some 400 basis points over government bonds. Another basket of more highly rated, comparatively ‘safer’ investment-grade bonds pays a measly 140 basis points over governments. No bad thing, surely?
The problem is that headline yields represent only a part of the total returns available from bonds; the other major contributing factors towards total returns are price movement and losses through default.
Investors who compare high-yield and investment-grade bonds on this basis will find they are more likely to receive a better rate of return from investment grade than from high-yield bonds.
That sounds counterintuitive. But two pieces of comprehensive and compelling analysis of historical performance should help make the case.
The first says that when high-yield credit spreads are at around 400bps, as they are now, the asset class is little more than a 50/50 punt for anyone with a three-year time horizon.
Figure 1 demonstrates this pretty starkly. It shows the three-year excess returns achieved by the same index from different points in the credit cycle. Clearly, high-yield bonds can generate spectacular returns, as the dots on the extreme right reveal. Anyone who purchased this index at the end of 2008 when spreads were at 1,230 basis points would have received a 63.58% return over three years.
But you can also lose your shirt. Way over at the left hand end of the chart sits a dot (representing an investment made in May 2007) that indicates a three-year loss of 8.13% when spreads were at 163 basis points. In other points in the credit cycle, three-year losses were -40.81%, -37.13% and -38.32%. The spread levels at the start of these periods of eye-watering losses? They were 554, 313 and 443 basis points, respectively – not too far off today’s 400 basis-point levels.
Aggregating all this data says that high-yield bonds can be a risky, volatile thing but you increase your chances of attractive, positive excess returns over three years by investing when credit spreads sit at a much higher level than they are today. If history is any guide, that level is around 800 basis points – nearly four whole percentage points above where spreads are today.
So, we know that a high yield bond index is little more than a toss of the coin at today’s spreads. But what should replace it?
The second piece of analysis suggests strongly that this should be investment-grade corporate bonds. This is the index, don’t forget, currently paying just 140 basis points over the sovereign.
Figure 2 explains why, again looking at three-year total returns of indices from historic spread levels. That means they also include price movement, something overlooked by those who glance solely at the headline yield.
By the way, this analysis looks at credit indices with financial issuers’ subordinated debt stripped out – because these instruments have far more in common with equities than bonds. It also assumes that no-one knows where spreads will go in future.
The work suggests that investment-grade credit and high-yield bonds sit either side of their long-term averages (141 basis points versus 91 for IG and 407 basis points versus 521 for HY). A move back to those averages implies that investment-grade credit spreads would fall and high-yield bond spreads would rise. Indeed, because investment-grade spreads are not as far advanced along the credit cycle, it suggests that, were spreads either to rise to their 75th percentile level or fall to their 25th percentile level, investment-grade would still outperform high yield.
Of course, an investor with the skills and resources to properly analyse high-yield bonds is likely to find some sort of use for them in a portfolio. But jumping in wholesale, at current spread levels, is nothing short of senseless.
Richard Ryan is the manager of M&G Investments’ Alpha Opportunities Fund