Monday, December 14, 2015

Tweeting High Yield: A Round Trip in Investor Sentiment

With high yield all the rage these days, I thought it might be worthwhile aggregating tweets / posts going back to the beginning of this credit cycle to outline where we've come from and to share some thoughts on where we might be going. Curious if this format is helpful or too disjointed.

Backdrop... how did we get from the distressed 2008 (a 20%+ index yield), to sub-10% yields and a risk on mentality?

In March 2009, corporate bonds appeared to be a screaming buy and the Fed had an outsized impact getting spreads (and yields) much lower - much quicker than I thought was possible.

Once things calmed, why was there a reach for yield? Because it was the only place where yields were high.
Why are Investors are Reaching for Yield?: Because high yield is just about the only place you can get yield...
Despite the reach, I didn't mind high yield back in 2012 when rates backed up to 8% given where we seemed to be in the credit cycle (i.e. early).

When did things get frothy? I'd say early 2013 when Yields went sub-5%

Yields went from over 8% to under 5% within 6 months. At that point (and since), I could not get my head around high yield valuations.
Especially when viewed relative to stocks, once the yield on high yield bonds < earnings yield on stocks.
I was far from the only person who saw the froth in high yield
High yield sentiment seemed formed by the strong 5 year performance of the asset class. But perspective on how that return was achieved appeared missing:
Interesting back and forth in comments of this tweet. Some very smart people couldn't see a situation I thought / think has a decent probability. High yield underperformance even without stock underperformance given extreme valuations of high yield.

High Yield Sentiment Flashed Warning Signs in 2014 - Very Briefly

The sentiment shift and my view that high yield investors could be well over their ski's became very apparent when high yield "sold off" just 2% in fall 2014 and investors viewed that as abrupt:
Despite that "sell-off", yields in the lowest quality segment were still absurdly rich, but investors calmed their fears and dove back in, despite crazy yields.

Recent Views: The Sell-off was Expected - It Doesn't Seem to Be the Crisis Others Want to Make It

Which gets us caught up to this year when I brought my blog back after a three year hiatus and I jumped right into an area of the market I felt was misunderstood:
Yet, DESPITE my views of how mispriced things were, until financials within high yield become more stressed, I am less concerned about the recent sell-off's impact on the overall market (though things can / do change quickly):
This is supported by the perspective on where current yields are (yields still aren't all that high) and relatively contained within energy:
In times like this, perspective is much needed (i.e. things haven't been bad by historical standards):
If an allocation to high yield is to be made, note that lower quality high yield has not led to historical outperformance:

Wednesday, December 9, 2015

It's Generally Smart to Avoid Credit Risk

I've previously outlined that high yield credit risk is typically less ideal than simply gaining credit exposure through stocks and rate exposure through bonds. Now Larry Swedroe outlines the case for avoiding investment grade credit risk altogether.

There are many well-documented anomalies in finance. Among them is the surprisingly small return that investors historically have earned for taking credit risk in fixed-income markets—the default premium, as measured by the difference in returns between long-term Treasurys and long-term corporate bonds, has been only about 0.3%—and that stocks with a higher risk of defaulting on debt have produced lower returns.
Going back to 1988, which is as far back as Barclays breaks down the returns of the Long Corporate Bond index into the contribution from credit and rates ex the spread, the return from the credit component has actually been slightly negative at -0.09% annualized vs the 8.12% return for a like duration Treasury bond. A similar story plays out in intermediate corporate bond space, where the credit spread contributes only 0.37% of the 7.24% return for the Barclays Corporate Bond Index since 1988.

The story is more nuanced than "credit always underperforms the yield" as yield is generally a great predictor of future returns, but yield should generally be viewed more as the ceiling for future returns than actual future returns. The issue is when there is stress in the market, such as during the financial crisis when 13 year cumulative performance (the rough duration of the index) of long corporate bonds underperformed the yield's "predicted" return by almost 80% (the 13 year forward performance starting in 1995 ended during the 2008 meltdown).

My general view of credit is to avoid it unless you feel you are being more than fairly compensated. Even if you miss shorter periods of relative outperformance (vs treasuries), allocating only when credit looks like a screaming buy will likely result in a much better long term return profile. In the case of long corporate bonds, allocating only when the spread of long corporate bonds to treasuries was greater than 200 bps (something that occured just 20% of the time), returned 1.1% annualized more since that same 1988 start.

Tuesday, December 1, 2015

The Case for an Allocation to Dollar Based EM Debt

While the underperformance of high yield bonds since my post The Case Against High Yield has certainly made high yield bonds more attractive (yields went from sub 6% to north of 8%), I still prefer the risk/return profile of a stock/bond allocation (more here). For those that are looking for a higher yielding fixed income alternative with limited currency risk and the potential for U.S. interest rate diversification, dollar based emerging market fixed income may be an interesting alternative.

What is it?

The Barclays EM USD Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. The index is broad-based in its coverage by sector and by country, and reflects the evolution of EM benchmarking from traditional sovereign bond indices to Aggregate-style benchmarks that are more representative of the EM investment choice set. 
At present the index is made up of ~75% sovereign debt and ~25% corporate debt, all denominated in the dollar, while the below table breaks down what it looks like in terms of country composition. Interesting to note that while only 2% of the portfolio is composed of Venezuelan debt, that 2% contributes more than 10% of the overall yield of the index (in other words, the higher yield is certainly not risk-free), but the index does provide a pretty wide breadth of exposure.

The EM Debt Relative Valuation Story

The case for EM USD Aggregate exposure is simply a relative valuation story. Despite periods of heightened turmoil within emerging markets over the last 20+ years, the yield to worst of the portfolio has generally been a pretty good predictor of future returns (note six years is used for the forward return projection given the duration of the index has fluctuated between around 5-7 years going back to the 1993 inception).

At the current yield of almost 6%, forward absolute returns are likely to be favorable.

The higher yield becomes more intriguing when viewed relative to the yield of the U.S. Aggregate Bond index. The below chart is similar to the one above, but is shown with yield to worst and forward returns relative to that of the U.S. Aggregate Bond index. In this case the relative yield advantage has been a pretty consistent precursor to future outperformance. A notable exception is the underperformance in the mid 1990's which coincided with six year returns impacted by the 1998 emerging markets crisis (though the yield advantage was sub 2% then vs almost 4% today).

While emerging market bonds are certainly not risk-free, the US dollar denomination protects an investor from a direct impact should the dollar continue to strengthen (though countries trying to pay back dollar denominated debt with a weakened currency are certainly indirectly impacted), while relative yields that are near all-time wide levels vs the US Aggregate index seem attractive given the "emergence" of emerging market countries on the global economy over the more than 20 years since the index incepted. Add in the potential diversification benefits moving some fixed income away from US monetary policy may provide and you get what is in my view a strong case for a strategic allocation to emerging market fixed income.