High Yield: Are Its Returns Too Closely Correlated to Equity for it to be Considered an Allocation to Fixed Income?

Posted on October 8, 2019

In previous blogs (Is There a Right Time for High Yield, part 1 and part 2), we suggested that high yield appropriately deserves a place in an investor’s overall strategic asset allocation. However, a common argument that we hear against such a decision is that it bears too much of a resemblance to an investment in equity. High yield has been described as a hybrid asset class; i.e., it displays the characteristics of both equities and fixed income. In fact, high yield does display a higher correlation to equities, and those who would not otherwise recommend an allocation to high yield may say that an investor could instead obtain a similar diversification benefit with higher potential returns simply by adding to an existing equity allocation. As a long-term investor in the high yield market, we unsurprisingly do not share these beliefs. Therefore, we compared the absolute and risk-adjusted performance of the high yield market to that of several equity markets to see what evidence we could uncover to either support or dispel this notion.


READ PREVIOUS POSTED BLOGS: Is There a Right Time for High Yield, part 1 and part 2


Exhibit 1 below shows that on average, for any starting option-adjusted spread (OAS) range over a nineteen year period, high yield performed in-line or exceeded the performance of the S&P 500 equity.

Exhibit 1:
Three-Year Average Annualized Returns for the period 1/1/1998 – 12/31/2016.

Exhibit 1

Five-Year Average Annualized Returns for the period 1/1/1998 – 12/31/2016.

Exhibit 1b

Perhaps these return figures lend support to the concept that high yield returns historically have behaved in a similar manner to equity and, accordingly, an allocation to the asset class provides a reward profile that tracks too closely to equities to warrant separate consideration. However, when these returns are paired with their respective volatility, as further set forth in Exhibit 2 below, the picture changes markedly.

In order to assess volatility (i.e., risk as measured by standard deviation), we have presented the Modified Sharpe Ratio for each index in Exhibit 2. In examining the charts below, one can observe that the risk and reward profile generated by high yield is very different when compared to the equity market presented.  While the data in Exhibit 1 demonstrated that the historical returns between the two asset classes have been relatively comparable; the risk-adjusted performance of the high yield market, given the differences in volatility as set forth in Exhibit 2, stands out at every OAS.


Exhibit 2:
Three-Year Average Modified Sharpe Ratios for the period 1/1/1998 – 12/31/2016.

Exhibit 2

Five-Year Average Modified Sharpe Ratios for the period 1/1/1998 – 12/31/2016.

Exhibit 2b

In our view, the correlation between the performance of high yield and the performance of equities makes sense. As overall economic activity improves or stabilizes, typically so do corporate financials, resulting not only in an increase in equity values but also a reduced likelihood of defaults, thereby providing a solid fundamental footing for high yield issuers to thrive. Consequently, both asset classes should follow similar paths in generating performance. However, volatility in high yield bond prices is typically muted relative to equity prices. For example, increases in the price of high yield bonds are capped, or otherwise restricted from appreciating endlessly, because of an event like an impending maturity, upcoming call date, or refinancing. More topically for many investors concerned with protecting the downside of their investment, only in the more extreme downside scenarios (e.g., default or bankruptcy) will the price of a high yield bond fall to zero, and even in many downside scenarios, high yield will typically recover more than the corresponding equity in the same issuer.

 


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About the Data

The period covered includes data from December 31, 1997 through December 31, 2016, or 19 years. We calculated the annualized performance for the high yield market, based on the returns of the BAML HY Index, at each month end date over several subsequent periods for each month end spread observed. From here, we used a simple average of the returns produced in each spread range, over each period, to generate the information displayed in Exhibit 1.

Performance for each market included in this paper was approximated using the following indices:

  • BAML HY – The BofA Merrill Lynch U.S. High Yield Index, which tracks the performance of U.S. dollar denominated below investment grade corporate debt publically issued in the U.S. domestic market.
  • S&P 500 - The Standard and Poor’s 500 Index, which is a U.S. market-cap-weighted index designed to capture the performance of 500 large-cap U.S. equities.

The Modified Sharpe Ratio is calculated by dividing the annualized return of the index by its standard deviation and is used as a way to compare the risk/reward efficiency of the two asset classes. Monthly returns were used to calculate both annualized returns and standard deviations. The calculation presented modifies the traditional Sharpe Ratio by eliminating the step that reduces the risky asset return by the return of the risk-free asset. We believe that this approach is appropriate because we are not necessarily concerned with the absolute level of the Modified Sharpe Ratios, but rather the relationship among such ratios for the indices presented.


The information and views expressed herein are provided for informational purposes only, and do not constitute investment advice, are not a guarantee of future performance, and are not intended as an offer or solicitation with respect to the purchase or sale of any security. The inclusion of particular investment(s) herein is not intended to represent, and should not be interpreted to imply, a past or current specific recommendation to purchase or sell an investment. Any projections, outlooks or estimates contained herein are forward-looking statements based upon specific assumptions and should not be construed as indicative of any actual events that have occurred or may occur. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Investing involves risk, including loss of principal. Investors should consider the investment objective, risks, charges and expenses carefully before investing with DDJ. Past performance is no guarantee of future returns.