The majority of individual investors don’t travel much beyond a diversified basket of investment grade debt securities for their conservative retirement income portfolio.
For those that assumed credit risk before the financial crisis, they were taught a stern lesson, and for those that picked up exposure thereafter, high yield bonds have masqueraded as a relatively safe equity-alternative.
I have even had recent conversations with individual investors that have plowed more money into high yield bonds over the last two months because they have not exhibited the same magnitude of decline or volatility that U.S. Treasurys, investment grade agency-MBS, or corporate bonds have. I believe it’s important that investors have a detailed knowledge of why that is, and position their portfolios accordingly for the future.
During this most recent selloff in bonds, unlike the 2008 financial crisis, interest rate sensitive securities have been more affected due to their very low yields. To simplify and recap what happened in the bond market during the 2008 credit crisis; banks and investors stopped lending because they lacked confidence in almost all borrowers’ ability to repay debt in light of the economic recession. Therefore every bond other than those without credit risk, such as U.S. Treasurys, fell in price. This is also commonly referred to as spread widening, since the spread between an average investment grade bond’s interest rate grew larger in relation to a comparable U.S. Treasury bond’s interest rate.
Today, the most recent rise in Treasury rates could be categorized as a repricing event due to fears of a future overabundance of securities in the system. This fear is manifesting itself now because of the Federal Reserve’s transparency with regard to changes in accommodative policy. Tapering the Fed’s asset purchase program has been translated into a tightening fiscal policy measure by the general market. In response to these facts, investors are demanding a higher yield for U.S. Treasurys because they have direct knowledge there will be a higher supply in the near future. This outsized supply will ultimately come from the largest purchaser of U.S. Treasurys, The Federal Reserve, withdrawing from the market. Credit and interest rate crisis scenarios obviously play into the easy to understand concept of supply and demand.
So why have high yield bonds outperformed U.S. Treasurys in the current market environment? Wouldn’t their interest rates rise alongside bonds with no credit risk?
Investors need only focus on the economy for their answer, as both growth and labor statistics are far better now than they were during 2008. There is also a level of confidence the U.S. won’t renter a new recession anytime soon. An easy to understand comparison can be drawn from the Guggenheim BulletShare 2018 Investment Grade Corporate Bond ETF BSCI, +0.01% and the Guggenheim BulletShare 2018 High Yield Corporate Bond ETF BSJI, +0.14% . Each fund carries a weighted average maturity of roughly 4.7 years, and each fund is designed to reflect a held-to-maturity/call basket of bonds. Obviously the largest difference between the two funds is average credit quality, reflected by a 2.37% SEC yield for the investment grade (IG) basket vs. the 5.47% SEC yield for the high yield (HY) basket. If you subtract the IG yield from the HY yield you get an additional 3.1% in yield for assuming additional risk of default.
However, the crux of the question and answer scheme doesn’t end there. Investors need to realize that the IG basket will track measures of inflation, changes in credit rating and treasury rates closely, therefore discounting the probability of individual issue default. In comparison, the HY basket will almost exclusively change in price based on the health of the economy, individual company fundamentals, and probability of default, therefore discounting changes in Treasury rates.
In addition, HY bonds get issued with shorter maturities and higher yields, two factors which inherently diminish the effect duration has on the price movement of a bond. Most HY bond issuers want inflation, as they will typically exert more earnings and growth momentum in an inflationary environment, leading to better balance sheets and lower borrowing costs when existing debt is rolled over or called away.
On the other hand, IG bonds start with longer maturity dates and carry high sensitivity to interest rates because their investors risk getting stuck with a bond paying below new issuance rates for an extended period. Most IG companies hate inflation as it inherently raises borrowing costs, compresses margins, and exerts difficulty on pricing power. To sum it all up, a bond’s duration is only a number, and doesn’t necessarily account for the type of environment it could perform well in.
In the very beginning of the bond market correction in May, all an investor would have needed to do was ask themselves whether they feared low levels of inflation and/or a recessionary environment, or if they felt the U.S. economy was on sure footing. High yield bonds were in a sweet spot in the early stages of the decline. As panic ensued, strategic investors quickly identified the selloff as a place to take advantage of the U.S. economies’ resiliency and more attractive HY bond prices.
However, the risk to reward profile today looks very different than it did in mid-June. This is primarily due to the opposite force of spread widening: Spread tightening. As high yield bonds began to recover, and interest rate sensitive bonds maintained their corrective trajectory, yield spreads have begun to compress. So the marginal benefit (difference in yield between BSCI and BSJI), or the excess yield an investor receives for the risk of default has essentially gone down.
As markets never remain the same for long, making changes to your portfolio will depend on the amount of credit risk you would like to assume juxtaposed interest rate risk. In our Strategic Income Portfolio we have clients focused toward a diversified basket of low duration high yield bonds and floating rate notes that have benefited from the near term market currents. However, looking forward we may see interest rates and risk assets lower by year-end than they are today. Allocating your own portfolio to take advantage of these cross currents is easy; you can even use the BulletShares to your advantage to define your maturity.
Understanding the changes taking place in the bond market will conclusively lead to well thought out changes to your retirement portfolio.
SOURCE: MarketWatch
