Have you ever been tempted to take a tactical, market-timing approach to high-yield? After all, waiting for spreads to widen and the market to become “cheap” seems like a lucrative way to play the asset class. However, history has shown us that this approach comes along with a litany of challenges, and that in reality, incremental increases in spread levels do not always translate into increases in total return.
This is the first blog of a series that is designed to provide some insight into the difficulty of applying a tactical, or short-term, mindset to high yield allocations and why, in our view, a strategic, or long-term, allocation to the asset class is optimal.
High Yield: Based on the averages, starting spreads are not a good predictor of returns
A tactical high yield investor might argue that the best use of their capital is to only invest in high yield when spreads (i.e., the difference in yield between a corporate bond and a risk-free government bond with a matching maturity or call date) are wide, and to do so for only a limited holding period until such spreads tighten. We disagree with both points, though we will naturally acknowledge that high yield investors should expect higher returns when spreads are wide and the market is “cheap”. With that said, we set out to determine whether the optimal allocation to high yield is tactical or strategic in nature.
For the analysis included in this section, we define a tactical investment as having a holding period of one year. Even this holding period may be too lengthy for some tactical investors who may see the window of opportunity as being much shorter than one year. However, for the purposes of our exercise, it allows for easier comparisons across time periods.
This exhibit is a panel chart displaying the average annualized return for the high yield market based on the starting option adjusted spread (“OAS” or “spread”) range measured in basis points over various time periods. The data presented in both the top and bottom panels are the same, but given the outliers that result at extremely high spread levels, i.e., OAS >1000 basis points (“bps”), the bottom panel of the graph rescales the data by capping the right hand side vertical axis at 15% to make visual comparisons easier. Average annualized returns presented were calculated using BofA Merrill Lynch data for the period January 1, 1998 to December 31, 2016. Source: BofA Merrill Lynch
Focusing on the one-year returns, the chart shows that wider starting OAS levels have resulted, on average, in a higher total return. At face value, this observation may seem to support the idea that an opportunistic investment in high yield is a good tactical trade rather than a more strategic allocation. However, from the bottom panel of Exhibit 1, we can also see that there have been several instances where the relationship breaks down, and higher starting spread levels have not always resulted in superior performance.
For example, the average one-year return for the high yield market when the starting OAS was between 300-399 bps (5.97%) exceeded that of the high yield market when spreads ranged between 400-499 bps and 500-599 bps (2.89% and 4.08%, respectively). In addition, the average one-year return when starting OAS ranged from 700-799 bps (6.39%) exceeded the average return of the high yield market when the starting spread was between 300-399 bps (5.97%), but only by 0.42%. This performance differential is less than one might have assumed given both the difference in starting spread levels (i.e., the relative “cheapness” of the market) and the return that one would expect to receive when paying less for an investment.
It is clear from the data that when spreads exceed 700 bps, history suggests that high yield investors should expect strong performance, on average, over all periods reported. That is not to say that there have not been examples over the past 19 years of less than desirable outcomes at those starting spread levels, but more often than not, the result has been positive. Unfortunately for tactical investors, periods of such elevated spreads occurred only about 25% of the time during the past 19 years, limiting the number of occasions for these investors to take advantage of such opportunities. For comparison, about 70% of the starting OAS levels during the period reviewed were between 300-700 bps.
In summary, the number of opportunities observed historically for tactical investors to participate in the high yield market and achieve an outcome, on average, that exceeded the performance generated at tighter starting OAS levels has been limited. In addition, the observation that an incremental increase in spread levels does not always translate into an increase in average return should give investors pause as to the effectiveness of a tactical allocation to high yield. In the next blog on this topic, we will review some of the characteristics that make high yield more suited as a strategic, long-term allocation for an investor seeking to maintain a well-diversified portfolio.
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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.