Replacing equities with high yield | Insight Investment | Insight Investment

Contents

• High yield returns have matched equities this century
• Default rates are lower than you may think
• Investors can achieve exceptional liquidity in high yield, essentially earning a “free” illiquidity premium

A potentially lower risk growth bucket, without sacrificing expected returns

It may surprise you that this century (i.e. since 2000), global equities have returned 4.8% pa, and global high yield has returned 6.5% pa. Despite this, high yield has been far less volatile, with a 10% annualised standard deviation, versus global equities at 16%¹.

The dispersion of outcomes has been narrower for high yield (Figure 1). Looking at rolling 5-year returns, high yield has a higher median return, and an inter-quartile-range that is roughly half that of equities. Further, high yield has rarely delivered negative rolling 5-year returns, unlike equities.

Figure 1: Over 5-year investment horizons, high yield has delivered equity-like median returns with lower dispersion²

Historically, high yield has also tended to benefit from more benign drawdowns during risk market sell-offs (Figure 2). This is partly because high yield bonds are senior to equity in the capital structure and generally have defined maturity structures, resulting in the “pull-to-par” effect: a maturing bond not in default will return principal. In equities there is no such guarantee, which can result in depressed valuations for extended periods.

Figure 2: High yield has historically recovered faster from drawdowns³

High yield default rates have been lower than you may think

Defaults are the main risk for high yield investors, as they threaten permanent losses of capital. However, consensus default predictions consistently exceed realised defaults in high yield indices. Ratings agency default expectations are typically in the range of 3% to 5% pa. But global high yield index defaults since 2004 have averaged ~2% pa on a par-weighted⁴ basis (Figure 3). This is partly because Moody’s and S&P’s default metrics are based on the number of issuers, rather than weighted by the bond size. Further, default metrics cover all speculative grade investments they provide ratings for. But these universes are wider ranging than what is included in the most indices, and thus unrepresentative of most institutional high yield portfolios.

Figure 3: High yield defaults in broad high yield indices have been contained⁵

Further, recovery rates are often forgotten. Loss-given-default (LGD) is a more important metric than default. Our analysis shows Global high yield recovery rates have been ~43% on average since 2004, resulting in a realised average LGD of ~1.2%.

When adjusting for average LGD, historically we have seen strong predictive power from initial option-adjusted spreads (OAS) and realised returns, indicative of the contractual nature of bond market returns.

This is demonstrable using the definition Expected Excess Return = Starting OAS– Expected LGD  (Figure 4).

Figure 4: Adjusting for LGD, spreads have strongly predicted returns⁶

A 'free' liquidity premium

The high yield market is infamous for its poor liquidity. This is certainly true when trading bonds over-the-counter (which is how almost all managers operate – Figure 5). The high transaction costs incorporating the additional illiquidity premium is a key factor behind the median high yield fund underperforming the broad index by ~50bp pa, net of fees.

However, innovations in portfolio construction and implementation technology that leverage the ETF infrastructure can allow investors to trade large, customised baskets of high yield bonds seamlessly to build a diversified and highly liquid high yield portfolio. We recognised this hidden pool of liquidity early on in 2012 and catered our investment process to benefit from this trend.

For years, we worked side-by-side with the sell-side community to improve their understanding as well to grow the “credit portfolio trading” market overall. As long as there is a vibrant ETF ecosystem, we are able to tap into this source of liquidity at a fraction of prevailing market bid/ask spreads.

Figure 5: Investors with in-depth knowledge of the ETF ecosystem can overcome liquidity constraints within high yield⁷

Importantly, investors that are able to leverage these innovations can essentially earn the asset class’s illiquidity premium for free.

It could be time to consider pivoting your growth bucket to high yield

During the quantitative easing era, equity allocations were well rewarded. However, in a post-QE world of normalised rates and the disappearance of the Fed put, the equity market is becoming a wilder ride. TINA (there is no alternative to equities) is dead.

We believe high yield – which for the first time in years lives up to its name with a current yield of ~9-10% – can play a particularly useful role in a pension plan’s portfolio. It can help grow the portfolio, add a measure of duration exposure and provide sizable and predictable cash flows to help meet obligations as they fall due.