High Yield Bonds -- Now Is A Great Entry Point

Includes: HYG, JNK
by: Downtown Investment Advisory

High Yield bonds were battered in Q3 2015 along with the stock market and most risk assets.

Weakness in oil & gas bonds have leaked into the overall High Yield bond market.

The effective yield of High Yield has shot up above 7.5%, up from 6% earlier in 2015 and to levels not seen in almost four years.

High yield has strongly outperformed stocks this century with less risk and will likely continue to do so.

Investors with a long term horizon should consider a larger allocation to High Yield bonds.

High Yield Bonds (HYB), also known by its misnomer "Junk Bonds," have received much negative press in the last few months, which is typical whenever HYB go down in price. HYB suffered a blow in Q3 2015, declining by 5.2% bringing the index down 2.4% for nine months 2015. Since quarter end, HYB has recovered by about 3.4% and is thus up about 1% in 2015. This follows a 2.5% gain in 2014, which was the weakest performance for HYB since 2008. 2014-2015 look like they will end up well below the average yearly gain for HYB of approximately 8% since 2000 (and over 10% since 1980). The weakness in HYB, which was in large part due to the crash in oil prices, as well as weakness in the stock market, has made HYB an attractive investment at this time for long term investors. The crash in oil related HYB, which have declined nearly 9% so far in 2015 (nearly 4x the decline of overall HYB), has tainted the entire sector and there are now many bargains - the window on these bargains may close soon. For those already in HYB, the long term prognosis remains bright in our opinion for those with diversified portfolios.

First, let's examine how HYB as an asset class and its performance relative to stocks. The chart below compares the S&P 500 to the Credit Suisse High Yield Index (one of several HYB indexes, all with similar results) for the last 5, 15 and 25 years through 2014. Over the past 25 years stocks have outperformed HYB, but only by 0.65% points (9.62% versus 8.97% annually), and more importantly, with nearly twice the risk! Over the past 15 years HYB have strongly outperformed stocks with almost double the returns and 40% less risk. In only the last five years stocks have outperformed, but simply because stocks took five years to recover from its 2008 low while HYB recovered full in only two years.

A closer look at the last 16 volatile years is instructive, and further highlights how HYB has clearly been the better choice compared to stocks this century. The chart below shows year-by-year returns for stocks and HYB, and calculates the annualized return from 1/1/00 to each yearly row in the chart. For example, from 1/1/00 through 2010 stocks returned 0.4% annualized while HYB came to 7.3%. We also added rows for 2016-2020 showing hypothetical returns for stocks and HYB. In order for stocks to match the return of HYB over a 21 period of time (meaning 1/1/2000 through 2020) stocks will have to return 16.5% per year for the next five years versus 6.0% for HYB. In this case each asset class will have a 6.5% annualized return over 21 years.

These are the key findings from the chart:

  • Since 1/1/2000, or nearly 16 years, HYB have returned 6.8% annually versus 3.7% for stocks, nearly double. HYB have done so with at least 1/3 less risk.
  • Stocks have experienced much sharper declines than HYB, with a 12% drop in 2001, 22% in 2002, and 37% in 2008. HYB has seen only one major plunge, 26% in 2008. The other declines in HYB have been in the 2% to 5% range. Since 1980 HYB have only decline five times, and only once by more than 6%.
  • The 2007-2010 period showed the resiliency of HYB compared to stocks. While HYB did plunge 26% in 2008 as all risk assets classes crashed, it recovered quickly in 2009 and easily surpassed 2007 levels in less than two years. Stock took much longer to recover, only exceeding 2007 levels in 2012.
  • It is unlikely that stocks will return more than 10% additional return than HYB for the next five years. It is thus almost certain that HYB will strongly outperform stocks for the 21 year period from 2000 through 2020.

There is an entire industry built upon the great promise that equities over the long run will outperform all asset classes, however, the last 16 years have placed serious questions on this notion (at least in our minds) and we will likely come to the same conclusion in 2020. Even looking back 25 years, which includes the bull market of the 1990s, stocks have barely outpaced HYB, and with much higher risk. If HYB have outperformed or matched equities with less risk over many decades why are allocations to HYB either very small in most model portfolios or even nonexistent? Isn't a 20 year window enough evidence to show that most portfolios should include larger allocations to high yield in lieu of stocks? While we certainly do not advocate that long term investors abandon stocks as they still offer the possibility for long term growth and are a key part of a diversified portfolio, HYB simply seems to be significantly underallocated. Why is this the case? Here are several reasons we have observed over two decades of professional investing:

  • HYB is misunderstood. Many consider HYB as an alternative asset class that is difficult to understand and illiquid, a "quirky" investment option like gold or emerging market stocks that should at best comprise 5%-10% of a portfolio, if at all. Any time HYB have a bad quarter, these negatives sentiments become more prominent.
  • Many falsely believe that HYB bonds are riskier than equities when in fact they are less risky. This is because bonds are higher on the capital structure compared to equities, and they generate a steady income which lowers volatility.
  • The phrase "junk bonds," which is a legacy of the late-1980s, continues to give the entire $1.5 trillion asset class a bad name. Many investors are surprised to realize that many S&P 500 companies (and even more companies in midcap and smallcap indexes) are also "junk bond" issuers, but would find it strange to call these stocks "junk stocks."
  • Bonds offer little to no upside above the yield one accepts at the time of bond purchase. The view is that bonds are "boring." Many investors are seeking opportunities to find the undervalued stock that will offer a big payday - the $3 trillion hedge fund industry is mostly premised on the idea of beating the stock indexes with winning stock picks (which the industry has stunningly failed to do year after year). Bonds offer no such upside. The fact that this HYB have outperformed stocks for the past 16 years is inconsequential. A corollary to this theme is that credit analysis is boring.
  • Many investors treat HYB as a "trading play" that one rotates into and out of based on various market conditions. When viewed as a trading play there certainly are times when HYB seems more or less attractive. But when viewed as a buy-and-hold investment, as fixed income should be, the short term gyrations of the HYB market are not very relevant. This is what is happening now in the market; declines in HYB creates negative momentum and investors are advised that they should "rotate out" of HYB. This kind of market timing has not been proven to work but it never dies.

By now it should be established that HYB as an asset class deserves far more attention from investors. Now we will discuss why October 2015 represents a particularly good time to rotate into this sector. Quite simply, the 5.0%-6.0% decline in HYB during Q3 2015 has made prices and yields for this asset class quite attractive. The effective yield for HYB is now over 7.5%, its highest level since 2012. The chart below shows the effective yield for HYB since 2011. Yields do not stay at these levels for long.

Downtown Investment Advisory's preferred strategy with HYB is to purchase and own the individual bonds and hold the bonds to maturity. When held to maturity, an investor can ignore the price movement of the bond, collect the interest, and get full principal back at maturity. By investing in a "curated" portfolio of individual bonds an investor can also eliminate the weaker companies that the high yield index funds by design must hold. Right now this would mean avoiding oil & gas companies and CCC bonds; Downtown Investment Advisory also specifically avoids bonds issued by private equity groups as experience has shown us that PE groups treat bond holders very poorly. For example, while the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) are good proxies for this investment class and an easy way to gain diverse exposure to HYB, these ETFs by design place the investor in many bonds we would avoid. There are many attractive bonds available today with five to seven year maturities that offer 6% to 8% yields, providing a fixed income stream for a multi-year period of time - without any exposure to weak oil & gas production companies.

What about default risk? HYB are certainly subject to defaults, and over the last 38 years the annual default rate for HYB overall is indeed 3.09%. When you net out the recovery rate of 43% over this time period (meaning that the average defaulted bond still returned 43 cents on the dollar to bond holders), the net default rate is 2.06%. This default figure includes the lowest rated CCC bonds; simply avoiding the lowest rated bonds would significantly lower the net default rate of one's portfolio. If we compared the historical net default rate of 2.06% to the historical yield-to-worst of all HYB over this same time period, which comes to 9.13%, we arrive at a net average return for HYB of 7.07% (9.13% less 2.06%) - which happens to match the performance of HYB from 2000-2015. In other words, the historical return figures discussed above already take into account all defaults.

Lastly, what about rising interest rates (which we are still waiting for after many years), usually the first question investors ask about bonds? The evidence shows that HYB are not affected much by changes in interest rates due to the higher yields that these bonds offer and the relatively short duration of the HYB market. A large percentage of HYB bonds have 4-7 year durations, leaving them less susceptible to interest rate movements. The chart below should allay fears that rising rates will negatively affect HYB. The data shows that in the last seven calendar years when the 5-year treasury rate rose, HYB actually had a positive return and outperformed other fixed income sectors - most recently in 2013. Does this mean HYB investors should hope for higher rates? The answer is no, the chart simply shows that there does not seem to be a relationship between rising rates and HYB. HYB is more affected by credit risk, general economic conditions and general performance of "risk" investments.

Please see the Downtown Investment Advisory profile page for important disclaimer language.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author holds high yield bonds in both personal and client accounts.