Volatility: High Yield Bonds versus Equities

Volatility has once again returned to financial markets over the last couple months, most visibly with wild equity price movements that we saw in February and again over the last week. While the high yield bond market certainly has not seen the extent of the volatility the equity markets saw, the rise in the 10-year Treasury yield has been an overhang in high yield as many are concerned about interest rate risk for fixed income securities.  While we believe this concern is valid for lower yielding, longer duration sectors (like investment grade corporate or municipals), high yield bonds have historically performed well in rising rate environments, helped by the fact rate increases generally correspond with improving economies.  This tends to alleviate credit risk, and high yield bonds benefit from their shorter maturity and higher yield, thus lower duration versus other fixed income alternatives (see our writing “Strategies for Investing in a Rising Rate Environment” for further detail).  Generally speaking, fundamentals for corporate credit remain solid and default rates are expected to remain low over the next couple years, which we feel positions the high yield market nicely.  Thus these periods of volatility like we have seen over the last couple months can create opportunities when they aren’t driven by a weakening credit environment/elevated credit risk.

Additionally, as investors look at how to navigate this return to volatility in financial markets, it is worth noting that over its history, the high yield bond market has had less volatility (as measured by the standard deviation) than the equity market, with a relatively similar returns profile.1

Within our own strategy, just over two years ago, we adjusted our strategy to deliberately include new and newly issued bonds.  Our goal with this strategic allocation was to reduce volatility and improve liquidity, as our experience had been, and market research supported, that high yield bonds tend to be even more liquid in the initial period following issuance as underwriters often support their deals and high yield managers look to add new bonds to their portfolios.

Volatility is a key measure of risk used by investors, and for those investors that are looking to reduce volatility versus equities while still generating income and potential upside, we believe that an actively managed high yield strategy can be an attractive alternative for investors.

1  Bloomberg Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on the average of 500 widely held common stocks. S&P 500 index data sourced from Bloomberg, using a total return including dividend reinvestment. Annualized Total Return and Standard Deviation calculations are based on monthly returns. Return/Risk calculated as the Annualized Total Return divided by Annualized Standard Deviation. Data as of 2/28/18.
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