Sure, high yield looks cheap these days, but that’s no reason to overweight it.
This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Larry Whistler, president and chief investment officer of Buffalo, New York-based Nottingham Advisors.
Thanks to the combination of strong returns over the past five years in the high-yield space and the continued suppression of short-term interest rates by the Federal Reserve, investor demand for subinvestment-grade bonds remains strong. Although the high-yield bond market has cheapened up some over the past six months, we remain cautious and continue to underweight the sector in our portfolios.
Our move from overweight high yield to neutral-to-underweight is based on three primary factors:
- The current risk premium for high yield debt is near its all-time low
- The quality of junk bonds continues to deteriorate
- Investor awareness of the potential for sell-offs in the space is low
To be clear, we still do own positions in some of the market’s biggest and most-liquid junk bond ETFs—such as the SPDR Barclay’s High Yield Bond ETF (JNK | B-68)—in our Global Income strategy, but we take a much more cautionary position relative to high-yield debt at this juncture.
So, let’s examine Nottingham’s circumspect attitude more closely.
Still Worth The Risk?
In June of this year, the BAML US High Yield Index reached its lowest spread over Treasurys since the financial crisis began. Since that time, the risk premium that investors receive over default-free Treasury securities has increased by nearly 100 basis points.
Still, at about +450 bps, the risk premium that investors are receiving is nearly 150 bps less than the average over the past 20 years for bearing the default risks associated with the high-yield debt market.
The justification for owning high yield at today’s levels stems more from its relative attractiveness versus other fixed-income sectors than from its own inherent value. Some would argue that today’s low-risk premiums merely reflect the low default rates currently in the high-yield space.
While this may be true, the corollary to that argument is that all the good news is currently priced into the junk bond market, and any subsequent bad news should be met with lower prices.
Relative to other asset classes, however, high yield appears overbought and its return profile increasingly asymmetric, in our view. Under current conditions, we would expect—at best—low to midsingle-digit returns over the coming year. Downside risks could be significantly greater should we see default rates rise or interest rates and credit spreads widen to more historical norms.
‘Junkier’ Than Usual …
Our second cautionary flag in the high-yield space stems from the increasingly poor quality of bonds being issued. With the drop in interest rates to historic lows, companies have been eager to issue debt to secure low financing costs.
At the same time, investors have been all too eager to absorb this supply as the options for income-seeking investors have dwindled. But investors are now being paid less for taking more risk, with many traditional bondholder safeguards forgone thanks to this high demand.
Much was written in late 2007 about the increased issuance of covenant-light loans and “PIK-toggle” (payment in kind loans) bonds. These are securities that shift more risk onto bondholders, giving borrowers more flexibility and allowing for less financial discipline. Covenant-light loans typically pare back some of the fundamental covenants put in place to help lenders detect early signs of borrower weakness.
“PIK-toggles” afford the borrower the opportunity to forgo cash interest payments to the lender until the refinancing or maturity date. These loans historically came with significantly higher risk premiums than are seen today.
Unfortunately, since 2013, these loans have made quite the comeback and, as the chart below indicates, covenant quality has been steadily worsening—a higher number means lower protection—as a result.
So, with yields near historical lows, bonds pricing in a low default rate and issuers taking advantage of investor demand, the overall quality of debt being issued continues to deteriorate.
Investors are unknowingly, by and large, taking on significantly greater risk without being paid for it. Lurking underneath the low quality dilemma is the potential for a liquidity-driven rout should investors look to exit en masse.
Restrictions imposed on banks via Basel and Dodd-Frank legislation have tied the hands of primary dealers in this space. These dealers have historically provided most of the liquidity in the market to retail as well as institutional investors. Restrictions on primary dealer holdings are already apparent and have led to much choppier price action in junk bonds. The fallout of these changes is this: Any large-scale selling could be met with a significant gap down in price before interested buyers enter the market.
Forced Into Unfamiliar Territory
Our third argument in favor of paring back high-yield exposure is based perhaps more on experience and is less data-driven. Simply put, there are many individual and institutional investors today who own high-yield debt who didn’t prior to 2008. This phenomenon was recently and aptly characterized by the Financial Times as “overenthusiastic buying by uninformed investors.”
Prior to the financial crisis, there existed an entire investor cohort, made up primarily of retirees, that invested almost solely in U.S. Treasurys and agencies, FDIC-backed bank CDs, and perhaps some very high-quality investment-grade debt. These cautious investors were intent on clipping coupons in order to meet a predetermined income mandate. Risk and volatility of return were not part of their investment equation.
A Vulnerable Class Of Investors
The Fed’s plan to save the economy by driving down interest rates and forcing investors outward on the risk curve has impacted this investor class perhaps more than most. In 2006, a 10-year U.S. Treasury note yielded 4.7 percent. Today it yields 2.3 percent.
The BAML US Corporate Bond Index had an effective yield of more than 5.5 percent in 2006. Today that yield is barely above 3 percent. Retirees dependent upon an investment portfolio to supplement Social Security or a company pension have seen their income from bond interest cut in half.
Not only is the income profile different, but so is the risk. Look at what happened between 2007 and 2008 at the onset of the crisis. Below we compare returns on government bonds against those on investment-grade corporate and high-yield bonds. Notice the dramatically different return profile of Treasurys in 2008 versus non-Treasurys.
Investors today, we would argue, have significantly greater exposure to the corporate and high-yield space by virtue of the different “income” and “unconstrained” bond funds being offered.
There are three ways to generate incremental yield in today’s market: use leverage; extend duration; or take credit risk. While some funds incorporate all three measures, many are strictly relying on credit risk to generate a return in excess of 4 percent.
Nottingham’s own Global Income portfolio has employed taking credit risk extensively over the past few years. More recently, however, we have actively pared back exposure to areas such as high-yield debt, bank loans and emerging markets. The risk/reward trade-off is no longer adequate, in our opinion.
We actively reduced our exposure to high yield in the second quarter of 2014. The recent pullback in high-yield spreads has given us an opportunity to re-enter the space. However, the pullback fell short of creating a true buyer’s market, as the global-equity rally drew investors back into the risk trade.
Taking A Break On High Yield … For Now
The high-yield trade today is exceptionally crowded, and not very rewarding, in our view.
While this asset class has performed admirably over long periods of time, the risk/reward trade-off today is clearly skewed—in favor of issuers or borrowers, and against investors, who are, let’s not forget, the lenders.
While we don’t anticipate a day of reckoning to be imminent, we do feel a cautious approach to high-yield exposure is warranted. Spreads are tight, issue quality is poor, and today’s buyer may not be fully aware of many of the risks lurking in this asset class.
Nottingham has liberally incorporated JNK, as mentioned above, as well as the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-68) and the SPDR Barclays Short Term High Yield Bond ETF (SJNK | B-98) in its asset mix. All three of these ETFs offer broad asset class exposure, are highly liquid and sport reasonable expense ratios.
Earlier this year, we exited the high-yield space in our multi-asset-class strategies, but continue to maintain a small exposure in our Global Income strategy.
The recent pullback in high yield put it back on our radar; however, at this point, we would like to see another 100+/- bps of spread-widening before re-engaging. As with all things in investing, timing and careful research are paramount to generating successful outcomes.
With respect to high yield, perhaps the best advice we can give today is caveat emptor.
At the time this article was written, the author’s firm owned positions in HYG, JNK and SJNK.
Nottingham Advisors is an ETF strategist that manages and advises on more than $1 billion in assets for advisors, institutions and individuals. Nottingham has been using ETFs since 2001 and currently offers five unique strategies with focuses on risk-based total return, current income and real return. To learn more, visit www.nottinghamadvisors.com or contact Nottingham directly at 716-633-3800. For all relevant disclosures, please go here.