04 November 2020

High Yield Investing Myths to Rethink in the Covid Era

High Yield Investing Myths to Rethink in the Covid Era

At a time when yields remain hard to come by, high yield bonds are an attractive option for many investors. Yet persistent myths about the asset class, including misconceptions about default risk, volatility, and sustainable investing considerations, continue to give many investors pause. Here we unpack four recurring myths about the high yield segment to help separate fact from fiction – and to give investors critical perspective when assessing opportunities in the asset class.

Myth No. 1: High yield is too risky across the board in terms of both defaults and volatility.

Misconceptions about the level of risk in high yield have become more entrenched during the pandemic, with investors concerned that renewed shutdowns could further dent business and sales, dry up liquidity, and eventually spur defaults.

Critically, as we outlined in a recent paper, defaults have been concentrated in the lower-end, CCC rating tier historically, which makes up just 12% of today’s high yield market. Even now, as the economy continues to grapple with the ramifications of the Covid-19 crisis, the trailing-12-month default rates for higher-rated BB and B credits have been just and 0.14% and 1.65%, respectively, as of 30 September 2020, compared with 42.9% for CCCs.1 As the chart below shows, similar bifurcations have been borne out in past downturns as well.

Source: BofA/ML, as of 30 September 2020. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change.

This is where taking a bottom-up approach to the asset class, focusing on fundamentals and looking at the actual sources of liquidity to companies, is critical. For instance, many companies with ample liquidity and stable earnings may have non-investment-grade credit ratings or scores due to the size of their debt. However, when we look at the reasons for taking on this leverage – e.g., a desire for greater tax efficiency or to increase return on equity – the ratings don’t tell the whole story, and may be masking an investment with a better safety profile than the rating would indicate. Moreover, central bank moves have tamped down default risk, creating what in many ways is a credit-picker’s market with an abundance of issuance.

Investors also frequently voice concerns about price volatility risk. Yet contrary to popular perception, the Sharpe ratio for high yield is actually quite high – in the upper third of liquid asset classes – largely because so much of the return component is coming from the coupon, which is consistent. In fact, higher-quality high yield debt has outperformed the S&P 500 going back 20-plus years in terms of total returns and Sharpe ratios.

Higher-Rated High Yield Credits Have Delivered Stronger Risk-Adjusted Returns

Source: Bloomberg Barclays as of 30 September 2020. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager, are valid as of the date indicated, and are subject to change.   Past performance is not indicative of future results.

Myth No. 2: High yield is a homogenous asset class – and will drop en masse in a recession.

The size and breadth of high yield issuance reveal a highly varied asset class with a nuanced response to economic downturns. The high yield market has already surpassed its previous record for annual new issuance this year, at $374 billion to date,2 and the $1.4 trillion in bonds outstanding span over 500 issuers across sectors ranging from financials to telecoms to energy companies 3 – with risk profiles that are equally diverse. Not all companies issuing bonds will earn less in a downturn, but sifting the winners from the losers requires an active approach to risk assessment and asset selection. As we like to say, don’t let the sliver of this market that is truly high-risk scare you away from an asset class that offers a range of risk profiles.

High Yield New Issuance Is Rising Across a Diverse US Market

US High Yield New Issue Sector Breakdown, Face Values (US$mn Equivalents)

Source: BofA Global Research as of 30 September 2020. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager, are valid as of the date indicated, and are subject to change.

Moreover, while broader-based dips in high yield bonds may coincide with equity market drops during downturns, we believe investors with a long-term view can and should look past these movements. The high yield segment has rarely, if ever, seen two consecutive years of negative performance. As the chart below shows, in previous periods of substantial spread widening, returns over the next 12- and 24-month periods bounced back strongly – indicating that such periods of spread widening may provide an attractive buying opportunity.

High Yield Returns Have Bounced Back After Prior Downturns

Bloomberg Barclays US Corporate High Yield Bond Index Returns Over Next 12 and 24 Months (%)

Source: Bloomberg Barclays as of 31 March 2020. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager and are subject to change.

Lastly, aside from being internally diverse, the high yield market also offers diversification relative to other asset classes, with generally low correlations to other fixed income sectors and less sensitivity to interest rate risk. As the chart below shows, interest rate risk drives a much lower percentage of returns for high yield and leveraged loans versus the US Aggregate, which derives a whopping 92% of returns from interest rate risk. And as noted above, high yield bond investments have also historically offered similar total returns to equity markets, but with lower volatility.

High Yield Returns Are Less Dependent on Interest Rate Exposure

Annualized Return Contribution (January 2000-December 2019)

Source: Bloomberg Barclays as of 31 December 2019. US Aggregate represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Leveraged loans represented by the S&P/LSTA Leveraged Loan Index. High yield represented by the Bloomberg Barclays U.S. Corporate High Yield Index. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager and are subject to change. Due to rounding, totals are approximate. Past performance is not indicative of future results.

Myth #3: High yield demand is lacking.

Another common concern we hear from investors is that demand for high yield is insufficient to meet supply amid a rise in fallen angels and substantial new issuance and refinancing activity. But recent flows tell a different story. As the chart below shows, while issuance and fund flows went south earlier this year as Covid concerns tightened their grip, the Federal Reserve’s backstopping of many fixed income market segments quickly sent trends in the opposite direction. We expect this trend to continue as investors extend their search for income in a yield-starved world. Yields currently available on a portfolio of high yield bonds look attractive relative to other fixed income alternatives.

Robust US High Yield Monthly New Issuance*

Healthy Demand for US High Yield Markets**

*Source: BofA and JPMorgan as of 30 September 2020. **Source JPMorgan as of 30 September 2020. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any opinions, projections, forecasts and forward-looking statements presented above are valid only as of the date indicated and are subject to change.

Myth #4: ESG and high yield investing are mutually exclusive.

There’s a general perception that lower-rated companies have weaker governance models, and that high yield allocations thus have heavier exposure to less environmentally-friendly industries and other “bad actors” in terms of environmental, social, and governance (ESG) factors. Yet despite some challenges, high yield and responsible investing can coexist – and attention to ESG issues through a research-intensive process can help uncover attractive responsible investment opportunities within high yield to create a best-in-class strategy.

As asset managers and fiduciaries, we believe the best way to address this challenge is through end-to-end integration of ESG considerations into our investment process – from asset selection, to due diligence, to engagement and monitoring – to seek to create portfolios that exceed market norms in terms of ESG. In our active approach, we see value in allocating capital toward companies with strong or improving ESG profiles, selecting the most attractive high-yield companies on both an ESG and a fundamental basis to tilt the portfolio toward those with solid ESG profiles, while also providing attractive investment opportunities. Consideration of ESG factors can also help better understand investment risk and evaluate whether the market is pricing that risk appropriately.

Key takeaways for portfolio positioning

In uncertain conditions like we’re seeing today, we think it pays to look past broad generalizations and take a more nuanced look when considering investing in any asset class. In high yield, we believe a focus on US dollar-denominated debt securities is prudent to maximize total return (consisting of current income and capital appreciation). We continue to focus on higher-rated bonds in the segment, with BB and B rated bonds a core component of our portfolios. Lower-rated credit, in the CCC area, merits a more tactical approach given the higher default risk for those assets.

For more investment insights into the high yield market, see “Why High Yield Doesn’t Have to Mean High Risk,” published 16 October 2020 on PineBridge.com.

Footnotes

1 Bank of America Merrill Lynch. CCC default rate peak as of 31 August 2020; BB and B default rates as of 30 September 2020.
2 Source: JP Morgan Securities new-issue data as of 9 October 2020.
3 Source: BofA and JPMorgan as of 30 September.


Disclosure

Investing involves risk, including possible loss of principal. The information presented herein is for illustrative purposes only and should not be considered reflective of any particular security, strategy, or investment product. It represents a general assessment of the markets at a specific time and is not a guarantee of future performance results or market movement. This material does not constitute investment, financial, legal, tax, or other advice; investment research or a product of any research department; an offer to sell, or the solicitation of an offer to purchase any security or interest in a fund; or a recommendation for any investment product or strategy. PineBridge Investments is not soliciting or recommending any action based on information in this document. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author, may differ from the views or opinions expressed by other areas of PineBridge Investments, and are only for general informational purposes as of the date indicated. Views may be based on third-party data that has not been independently verified. PineBridge Investments does not approve of or endorse any re-publication or sharing of this material. You are solely responsible for deciding whether any investment product or strategy is appropriate for you based upon your investment goals, financial situation and tolerance for risk

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