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Too close to call — The impact of election results on high-yield returns

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.

Let me say at the outset that nothing that follows should be construed as a prediction of the outcome of next month's presidential election. Furthermore, readers should absolutely not interpret any portion of the commentary below as an opinion about which candidate should win. I would never presume to advise anyone how to vote. Neither would I suggest that high-yield bond investors should cast their votes solely or primarily on the implications for either the expected near-term or longer-run impact on speculative-grade returns of the asset class.

With those provisos, the analysis below explores two aspects of the upcoming election. First is the historical record of the immediate price impact of the outcome, with a focus on which party's candidate emerges victorious. The second focus is historical high-yield returns by party during presidential returns.

MORE FRIDSON: No, the high yield index does not ignore default losses

Price changes in week following election
The eight elections for which ICE Indices LLC daily price returns are available are equally divided between Democratic candidate victories, indicated in blue in the chart below, and Republican candidate victories, indicated in red. In the week following the four election days on which a Democrat won, the high-yield index rose twice and fell twice. Republican-candidate triumphs were similarly followed by two gains and two losses. Based on the admittedly small number of available observations, the probability of a pop is as great as the probability of a drop between Nov. 3 and Nov. 10, whether Donald Trump or Joe Biden wins. That is to say, returns in the immediate aftermath of next month's election will most likely be determined by factors other than the election results, with a possible exception in the event of a contested outcome.

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In the 2000 case, the winner remained uncertain on election night, and one week later. The high-yield market fell during that period. It is therefore not unreasonable to expect it to fall if the outcome remains in doubt when the market opens on Nov. 4. For a detailed discussion of the expected impact of a disputed election, see "What if election gets hung? + industry valuation update" (LCD News, Nov. 8, 2016). In addition, "The returns are in! Post-election HY performance" (LCD News, Nov. 15, 2016) analyzes the immediate impact of the most recent presidential contest by rating, maturity and industry.

The 2000 election was also noteworthy as the one instance of the eight in which control of the Senate or House changed in conjunction with a quadrennial presidential election. (Other handovers during the period occurred in off-year votes, with the House majority switching from Democrats to Republicans in 1994 and from Republicans to Democrats in 2006.) Some political pundits currently see a non-negligible chance that the Republicans will yield control of the Senate to Democrats this time around. The high-yield market declined the last time Democrats captured the Senate in a presidential year, although the abovementioned dispute over the outcome of the presidential race may have been the dominant factor.

As for the present, some market pundits have recently asserted that the stock market is now interpreting the possibility of a Democratic sweep as potentially good news. According to their revised thinking, completing the Democrats' control of the legislative branch and adding the presidency would produce massive fiscal stimulus and a consequent corporate earnings boom. This pivot from the solons' previous pronouncements, which emphasized prospects of higher taxes and regulatory barriers under undivided Democratic rule, sounds to me more like a rationalization of an unexpected stock market response than a fresh thesis based on new fundamental developments. Be that as it may, let us remain focused on financial, rather than political, analysis.

Sector take
Managers of portfolios dedicated exclusively to high-yield bonds will not be entering or exiting the asset class based on interim performance expectations. Their interest in the impact of the Nov. 3 vote, rather, lies in the expected behavior of sectors within high-yield. Unfortunately, historical price returns displayed in the previous table do not provide perfectly clear-cut guidance on the ratings mix decision.

As discussed in "Monthly recap plus segmented demand" (Oct. 6), financial theory holds that the riskiest securities ought to be the most sensitive to changes in perceived risk. By that logic we should expect the lowest-rated issues to post bigger losses than their higher-rated counterparts in down markets and bigger gains in up markets. We should therefore expect the first-week-post-election price changes for all eight years in our observation sample to appear in the northeast (BBs perform better in down markets) and southwest (CCC & Lower issues do better in up markets) quadrants of the matrix chart below.

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In reality, two of the eight years in our sample appear in the "wrong" boxes. During the 1996 up week, BBs not only gained more than CCC & Lower bonds, but rose sharply, while the bottom-tier bonds actually declined. When high-yield bonds fell in the 2016 election aftermath, BBs once again ignored the script and fell by more than CCC & Lower bonds. On balance, short-term traders who expect high-yield bonds to fall in the wake of the Nov. 3 polling should overweight BBs, while those who expect a rally should overweight CCC & Lower issues. They must recognize, however, that there is a not inconsequential chance that such positioning will backfire on them even though they call the overall market direction correctly. (This is a problem I have dubbed "instrumentality," as discussed in "Instrumentality: An Underestimated Risk Factor" (co-authored by Jón G. Jónsson), The Journal of Portfolio Management, Fall 1995, pp. 9-20.)

Republican vs. Democratic administrations
Investors with a longer horizon are less concerned about performance in the immediate aftermath of the election than prospective returns during the impending Trump second term or Biden first term, as the case may be. The table below shows that a simplistic, party-based model is inadequate for projecting high-yield return over the course of a presidential administration. This is despite the fact that the mean annualized return during the Republican (red) administrations was just 5.89%, versus 10.38% during the Democratic (blue) administrations. That difference, by the way, does not come close to being statistically significant, owing to the very small sample size.

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The complication is that the high-yield index's return over a four-year span is strongly influenced by the yield at the beginning of the period. In the four presidential terms that began with an index yield greater than 10%, the mean annualized total return was a robust 13.13%. By contrast, the mean return was a paltry 3.14% in the four years in which the beginning yield was less than 10%. Averages can be deceiving, but not in this case. The lowest return in the first group comfortably exceeded the highest return in the second group. Based on this finding, a president who happened to enter office with high-yield bonds yielding in double digits cannot automatically be said to have done a better job for high-yield investors than one who had the bad luck to be inaugurated while the speculative-grade yield was in single digits.

A more valid test that eliminates the handicaps imposed by yield at the outset of the administration is the net realized return shown in the chart, i.e., the annualized return minus the beginning yield. The Democrats prevailed on this basis, as well, but by a smaller margin, -0.875% to -4.00%. This result, too, fails to pass the test of statistical significance. Considering the available evidence, institutional investors with a four-year horizon should certainly not base their high-yield allocations primarily on the party that will be in power as a result of the 2020 presidential election.

Research assistance by Lu Jiang and Zhiyuan Mei.

ICE BofA Index System data is used by permission. Copyright © 2020 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.