A Time to Consider High Yield Bonds?

When working to forge the United Nations after World War II, Winston Churchill is reputed to have quipped: “never waste a good crisis.” Seventy years later, in a different kind of crisis, it’s again a time for reflection and review. In the case of investing, the global pandemic has triggered an economic recession, making this a logical time to prioritize portfolio diversification.

To quote another figure from history, US financier Andrew Mellon is reported to have stated at the time of the 1929 Wall Street Crash that “gentlemen prefer bonds.” Although financial market folklore sometimes confuses this with the title of a 1953 Marilyn Monroe film “Gentlemen prefer blondes,” in fact Mellon’s original meaning was more practical. His point being: an educated person’s portfolio should include some bonds.

My experience is that, in recent years, investors have allocated increasingly to equities at the expense of fixed income. Yet diversification into bonds would have reduced losses in March’s sharp bear market. Looking forward at a time of continuing economic uncertainty, fixed income has a role to play in diversifying and reducing a portfolio’s risk.

But what of the returns at a time of record low yields?

The search for yield¹

As the COVID-19 pandemic has unfolded, yields on euro sovereign and quality corporate bonds have remained extremely low. For example, despite France’s massive increase in state spending to support the economy, the country’s 10-year government bond yield was 0.0% at the end of May, up slightly from -0.3% at the end of February, before the pandemic hit financial markets. Turning to high quality euro corporate bonds, even the yield on the VanEck iBoxx EUR Corporates UCITS ETF was just 1.1% in late May.

But the returns on high yield bonds have risen significantly. For example, the yield on the VanEck Global Fallen Angel High Yield Bond UCITS ETF increased from 4.0% at mid February to 6.2% as 26 May, see figure 1. Please be aware that yield is inversely related to actual performance. Overall, the performance of the ETF has been negative since the start of the COVID-19 pandemic. This ETF invests in corporate bonds which were investment grade at the moment of issuance, but have since been downgraded to sub-investment grade.

Figure 1 – Yield of the VanEck Global Fallen Angel High Yield Bond UCITS ETF

Past performance is not a reliable indicator for future performance. Source: VanEck. Data for the period 27/5/2019 – 26/5/2020.

What we learn from institutional investors

Despite the derogatory labels of “sub-investment grade” or even “junk” bonds, many institutional investors allocate to this asset class. According to Mercer, the consulting firm, 10% of European pension funds have a strategic allocation to high yield bonds². Actual allocation will probably be higher, as many allocate to it as part of broader credit mandates. According to S&P, the high yield market constitutes roughly 15% of the corporate bond market³.

However, not many individuals have a pension fund’s resources or expertise. Let’s therefore spend some time discussing how to assess the risks.

Assessing the risk

High yields bonds contain three main sources of risk:

• Credit risk
• Market risk
• Currency risk.

Each of them needs to be viewed in different ways.

Credit risk

Credit risk is the risk that a bond defaults. In other words, the corporate borrower issuing the bond cannot make its regular coupon payments or redeem the principal. But how can individuals even begin to estimate default risks? What can help, as a first step, is looking at historical default rates. As we can see in figure 2, they have averaged 4.0% over the last 37 years for global high yield bonds, rising in recessions and falling back in recoveries.

Figure 2 – Historical default rates of global high yield bonds

Source: S&P - Default, Transition, and Recovery: 2019 Annual Global Corporate Default And Rating Transition Study.

A next step is to peer more closely at the bonds and judge their quality, which tells us whether they are likely to default. Fortunately, credit rating agencies exist to do just this. The VanEck Global Fallen Angel High Yield Bond UCITS ETF shows you, in figure 3, the different ratings of the bonds it includes – starting from higher quality BB+-rated bonds and going through to the few bonds rated CCC-. Turning to figure 4, you can see the records for how different rating categories have defaulted over 20 years. While it is important to note that history does not repeat itself, it often rhymes. In other words, it gives an idea of the patterns you might see, or the probability of default.

Figure 3 – Rating distribution⁴ of VanEck Global Fallen Angel High Yield Bond UCITS ETF, based on market cap

Source: ICE, data as of 30/4/2020.

Figure 4 - Global Corporate Annual Default Rates By Rating Category (%)⁵

Source: S&P Default, Transition, and Recovery: 2019 Annual Global Corporate Default And Rating Transition Study.

It’s important to note that even when bonds default, the investor does not always lose the full value of the bond. That’s because the liquidator of the company will recover as much value as possible. Again, taking history as a guide, recovery rates for US bonds have been 47%⁶.

In technical market jargon, one minus the recovery rate is called the “loss given default”. By multiplying the probability of default with the loss given default, one can anticipate the expected loss of a bond. Normally the mechanics of financial markets mean that the expected loss should be lower than the bond’s interest rate spread over sovereign bonds. Otherwise there would be no incentive to buy high yield bonds. However, markets can be wrong and actual defaults might be higher than yields suggest.

Market risk

Even if a bond does not default, prices can fluctuate as investors become risk averse and require higher yields to compensate for the risk of investing. For long-term investors, this should make little difference – the bond will eventually be repaid at face value when it matures, so market fluctuations don’t matter. However, in the short term, the investor’s portfolio can decrease in value. In figure 5, we compare the volatility of high yield bonds with that of sovereign bonds and equities. We can see that it is roughly in between the two, but closer to sovereign bonds than to equities.

Figure 5 – Annual volatility of various asset classes

Past performance is not a reliable indicator for future performance. This also holds for historical market data.
Source: VanEck. For sovereign bonds the VanEck iBoxx EUR Sovereign Diversified 1-10 UCITS ETF has been used, for high yield bonds the VanEck Global Fallen Angel High Yield Bond UCITS ETF and for equities the VanEck Global Equal Weight UCITS ETF. Data for the period 19/3/2018 (launch of the VanEck Global Fallen Angel High Yield Bond UCITS ETF) – 26/5/2020. Using longer periods leads to comparable results. Do note that the SRRI scores of the three ETFs are respectively 3, 4 and 5 and hence are in line with the above analysis.

Obviously, market movements are not always a bad thing. Sometimes it works in the investor’s favor. If investors become less risk averse or markets look more positively on the credit cycle, spreads should tighten and bond prices will rise.

Currency risk

Finally, it is important to note that EU investors take a currency risk if they buy non-euro denominated bonds. Should the euro rise against the currency of the bond, the value of the bond for a euro investor would decrease. Again, this goes both ways: if the euro fell in value, the bond would increase in value for EU investors.

Conclusion

So, this crisis is a good time to think about lifting allocations to bonds, and especially high yield bonds as they still offer attractive returns. Of course, Churchill would likely be in favor of investors reviewing their options after such a momentous crisis, although history does not relate his liking for bonds (or indeed blondes for that matter).