Is There a Right Time for High Yield, part 2

Posted on September 26, 2019

This is the second blog of a series which is designed to provide some insight into to 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.

Exhibit 1 below displays returns for the high yield market over various holding periods based on different starting spread level ranges. It can be seen that, on average, extending one’s holding period has historically resulted in better outcomes, especially for starting spreads that have ranged from 300 to 700 bps, which are the levels that high yield spreads have been most-regularly observed and what we define for the purposes of this blog as “normal market conditions”.

Exhibit 1 - Average Annualized Returns by Spread Range

This point makes sense when one considers that, over the long term, substantially all of the high yield market’s return has been generated by coupon income, with price appreciation having little to no contribution to returns over such timeframe.  Therefore, we believe that extending one’s holding period enables short-term dislocations in bond prices, typically caused by technical factors or “noise” surrounding a particular issuer or industry that generally have no impact on the long-term fundamental health of the impacted issuer(s), to smooth themselves out, while also allowing the coupon income received to compound over time.  DDJ’s research process focuses on the fundamental health of an issuer over the long-term.  If a company is fundamentally sound, and continues to pay its coupon, any market price declines experienced will usually reverse as the bond or loan approaches maturity and it becomes apparent that the issuer will be able to refinance its debt.

The two scatter plots in Exhibit 2 below further support this conclusion. These show the performance of the high yield market, over three- and five-year holding periods, using the most frequently observed starting spread levels (i.e., OAS between 300-700 bps) based on month end values.

 

DDJ Blog

One can observe from the data that there is a great deal of variability among the outcomes at these spread levels, which suggests two things. First, under normal market conditions, starting spread levels themselves have not been a strong predictor of future performance, which one can infer from the lack of any real pattern in the data in the two charts.

Second, extending one’s holding period greatly reduced the likelihood of experiencing negative returns for a high yield investor.  Based on the second scatter plot above, a longer holding period would have enabled the investor to extract more of the benefit of the coupon income provided by the asset class, thereby mitigating the impact of any shorter-term price fluctuations.  Both of these scatter plots, and in particular the second plot depicting a 5-year holding period, also highlight the “opportunity cost” in the form of attractive returns that tactical investors often forego if they elect to wait for spreads to reach a certain level (e.g., 800 bps) before otherwise investing in the high yield asset class.

We believe that the points outlined above support a strategic allocation to high yield by investors who are seeking a well-diversified portfolio.


FURTHER READING: Interested in reading the first blog in this series? Click here to read part 1 of Is There a Right Time for High Yield


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