This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC as well as a contributing analyst to S&P Global Market Intelligence.
Various media outlets recently heralded the first-ever drop in the high-yield index yield to less than 4%. The edge was taken off a bit by the fact that as measured by the effective yield on the ICE BofA US High Yield Index, that "psychologically important" barrier still has not been breached. To date, the low on that index and by that metric is 4.08%, recorded on Feb. 15, 2021. What triggered the headlines was the yield-to-worst decline on the Bloomberg Barclays US Corporate High Yield Index to 3.96% on Monday, Feb. 8, from 4.03% on Friday, Feb. 5. Also in YTW terms, the ICE BofA US High Yield Index's yield dipped to 3.98% on Feb. 9, from 4.01% on Feb. 8.
Not that a drop from four-something to less than four-something has any real significance, in the bond market or elsewhere. Almost everyone knows the name Roger Bannister. He was the first man to run a mile in less than four minutes, accomplishing the feat on May 6, 1954, in 3 minutes, 59.4 seconds. Few know the name John Landy, the man who broke Bannister's record 46 days later with a time of 3:57.9. Does it make sense that the athlete who accomplished the greater feat is the less celebrated one?
In the wake of the news of the Barclays index's first-ever three-handle, I heard from multiple parties the suggestion that high-yield now needs to be renamed. I have been hearing similar remarks ever since the ICE BofA US High Yield Index's yield-to-maturity (the only metric then available) dropped below 10% for the first time on July 8, 1993. (The index's yield temporarily climbed back into double digits numerous times after that date.) To many market veterans who recalled new issues of relatively strong speculative-grade credits issuing at mid-teens levels in the 1980s, the sub-9% yields of the late 1990s simply did not qualify as high, yet they were more than twice as high as today's.
Such comparisons are the essential point regarding nomenclature. "High" yield has always really meant a yield "higher" than something else. If that were not the case, i.e., if "high" yield were defined in absolute terms, we would have to go back and reclassify Treasurys circa the late 1980s as high-yield bonds. The ICE BofA 30-Year US Treasury Index's YTM hit 9.47% on Aug. 25, 1988.
At 4.12%, the ICE BofA US High Yield Index's effective yield as of Feb. 19, 2021, was 2.09 times that of the investment-grade ICE BofA US Corporate Index's 1.97%. Last I checked, a yield twice as great as another qualifies as being higher. By this standard, high-yield bonds deserve their name no less than in the past. One might even argue they are more deserving; since the December 1996 inception of effective yield data, the HY-IG ratio has averaged 1.86:1.
In short, high-yield bonds require no rechristening. For anyone who insists otherwise, alternative monikers are readily at hand. They include "speculative-grade," "non-investment grade," and "below-investment-grade," abbreviated to "BIG" by fixed-income expert Richard Lehmann. And yes, there is the financial media's preferred term, "junk bond." Editors allow this slanted term, which conveniently takes up less headline pace than the others, probably believing it is the original and correct term. In reality, "junk" is attested no earlier than the 1920s and then not exclusively for bonds, while John Moody used the purely descriptive "high-yield" at least as early as 1919.
What to do about the yield shrinkage
None of the foregoing is intended to suggest that a speculative-grade yield of 4%, give or take, is attractive in light of prevailing risks. (See our latest Fair Value update in Oil price surge prompts Energy rally in US high yield market). If you are looking for a culprit, though, cast your gaze upon the Fed. With help from the central bank's quantitative easing, the ICE BofA US Treasury Index's Feb. 19, 2021, effective yield stood at 0.80%, which compares with a 1997-2020 mean of 3.14%.
Extraordinarily low underlying Treasury yields and a high-yield option-adjusted spread (OAS) of +341 basis points combined to produce a Feb. 19 effective yield of 4.12% (see note 2). The high-yield OAS was not a record low, but exactly 100 bps greater than the all-time minimum of +241 bps on June 1 and June 5, 2007. Yes, the spread was well below its historical mean of +554 bps and too low for the prevailing risk, according to our Fair Value analysis, but the Fed can take credit for that as well. By intervening in the corporate bond market for the first time ever, even going so far as to state a willingness to dip into the high-yield category to prop up recent fallen angels, the monetary chieftains have caused at least some investors to believe they are stopped out, regardless what prices they pay.
No matter how they come down on these questions of financial theory and policy, high-yield portfolio managers face certain practical pocketbook issues. Wrongly, in our view, many mutual fund investors may attach significance to the Feb. 9's drop of 7 bps on one version of the speculative-grade yield. They may consequently decide to reallocate to some other asset class they consider reasonably priced — if such an asset class exists in the current market. Meanwhile, PMs whose institutions charge them with funding known liabilities may urgently need a yield boost.
Whatever their affiliation, PMs must confront the reality that yield and risk are positively correlated, notwithstanding the fact that they spend much of their time looking for cases of imperfect correlation. How, then, can they offset the ebbing tide that lowers all the high-yield boats, without creating a serious risk of capsizing? (Apologies to John F. Kennedy, who popularized — but did not originate, contrary to popular belief — that adage about rising tides).
Some combination of strategies will likely represent the safest approach to offsetting the decline in speculative-grade yields. One to consider, for PMs whose guidelines permit it, is to enlarge the portfolio's emerging markets component. The table below addresses the associated risk-reward impact.
Currently, the ICE BofA US High Yield Emerging Markets Corporate Plus Index (Symbol: EMUH) out-yields the ICE BofA US High Yield Index (H0A0) by 152 bps. Its OAS advantage is +162 bps. By historical standards, those differentials are either fair or somewhat generous, depending on the historical period specified. (A key decision in selecting the base period is whether or not to include the years of the Global Financial Crisis. We display the data both ways so that readers can exercise their own judgment on the matter).
The historical comparison is not compromised by any change in the relative credit quality of EMUH and H0A0 over time. Both indexes' Composite Ratings have been stable, at BB3 and B1, respectively, since 2005. This raises the question of why the consistently higher-rated emerging markets index's risk premium has long been considerably greater than the lower-rated US High Yield Index's.
One possible explanation is that investors override the rating agencies' assessments on the grounds that rule of law, and by extension protection of property rights, is less well entrenched in EM countries than in the U.S. That hypothesis is difficult to test, but the last column in the table above provides a simple explanation for at least part of the seeming anomaly. Whatever the reason, EM is more volatile than H0A0. Given Modern Portfolio Theory's equating of variance with risk, EM's higher average OAS makes sense. The minor differences between the two asset classes in average maturity and effective duration will likely have little impact on the comparative spreads (see note 1). Neither does currency risk enter the picture, for as EMUH's full name indicates, its constituents are U.S.-dollar-denominated bonds.
Based on the foregoing analysis, I believe portfolio managers can be confident that enhancing their yields by dipping more deeply into EM is not the financial equivalent of Russian roulette. Naturally, they cannot simply rely on the aggregate statistics and select issues at random. The good news is that meaningful yield pickups on swaps into like-rated issues are available even at the highest quality level within speculative-grade.
The table below shows a 60 bps yield spread between BB rated issues in the EM and U.S. high-yield indexes. Even PMs who question whether the default risk of an average EM bond of a given ratings equivalent to that of an average like-rated US bond should not fear that they are materially raising the near-term default risk of their portfolios by replacing a few U.S. BBs with EM BBs. They should of course have their analysts carefully study the purchase candidates. An initial screening for issues with Positive outlooks from the rating agencies might be a good way to identify the most promising candidates.
High-yield portfolio managers who are under pressure to counteract the recent decline in yield cannot afford to ignore the risks of doing so. Achieving the objective solely by downgrading in quality or extending duration can leave the portfolio dangerously exposed to an economic setback or interest rate spike. A diversified yield-boosting strategy strikes us as more prudent and increasing the emerging markets, if investment guidelines permit it, is one way of pursuing that approach.
Research assistance by Bach Ho and Ducheng Peng.
ICE BofA Index System data is used by permission. Copyright © 2021 ICE Data Services. The use of the above in no way implies that ICE Data Services or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Lehmann Livian Fridson Advisors LLC's use of such information. The information is provided "as is" and none of ICE Data Services or any of its affiliates warrants the accuracy or completeness of the information.
1. Sharp-eyed readers will note that on Feb. 19, 2021, EMUH had a slightly longer average maturity and effective duration than H0A0, while historically H0A0 had the greater term risk. This relationship flipped in April 2020. In that month, Petroleos Mexicanos Internacional (Pemex) entered the emerging markets index as a fallen angel. Its outstanding debt included $21.8 billion with remaining maturities of 20 years or more. Note that the change in comparative average maturities does not affect a portfolio manager's ability to make well-considered substitution swaps from U.S. high-yield issues to like-rated, similar-maturity EM bonds.
2. The ICE BofA US High Yield Index's effective yield of 4.12% is not the sum of its 341 bps OAS and the ICE BofA US Treasury Index's 0.80% effective yield, which would be 4.21%. Calculation of the OAS is based on the average of spreads of the high-yield index's constituent issues versus the yields on their corresponding-maturity Treasury issues. The distribution of Treasury maturities brought into the calculation in this way does not precisely match the mix of maturities within the Treasury index.