The past year saw high yield bonds rally strongly in the wake of March’s Covid-driven selloff as growth rebounded and a widely expected wave of corporate bankruptcies failed to materialize.
Still, the volatility had an impact on investors, and different high yield bond portfolios performed differently. From February 28, 2020 through March 31, 2020 low volatility high yield fell by -6.13% (using the S&P U.S. High Yield Low Volatility Corporate Bond Index– as proxy). Fallen angels – the bonds of one-time investment grade companies that have since seen their credit quality decline – lost -13.10% over the same time period (with the ICE BofAML US Fallen Angel High Yield Index as proxy).
This divergence reflects, in part, the underlying characteristics of the securities. Fallen angels tend to have a longer maturity and are therefore more sensitive to both credit and interest rate changes. Low volatility seeks to invest in bonds with lower credit risk as indicated by the “Duration Times Spread” metric, which are typically less sensitive to these factors. This can also be seen in how the two strategies recovered in the months following the start of the Covid crisis. Fallen angels led the way, up 25.04% for the period April 30, 2020 through March 31, 2021, compared to 8.63% for low volatility. By way of comparison, the high yield benchmark, the ICE BofAML US High Yield Index, climbed 18.79% over that time.
Both fallen angels and low vol strategies have attractive up and down participation relative to the high yield benchmark, but with different risk factors. Low volatility captures about 0.79 of up beta, and 0.47 of down beta compared to the benchmark. The comparable numbers for fallen angels are 1.25 and 1.10.1 This suggests that a strategy that combines the two has the potential to provide a more optimal solution for investors, and our research has shown this to be the case.
Introducing fallen angels to a portfolio with a 100% low volatility high yield strategy, investors experienced higher returns but lower drawdown risk as compared to the high yield benchmark until the allocation to low volatility fell below 30%. Based on the current 12-month dividend yield of the representative ETFs for the three indices (HYLV for low volatility, FALN for fallen angels and the HYG for the benchmark), mixing up to 30% of the low volatility high yield strategy with fallen angels gave investors similar or higher income than the high yield benchmark.2
High yield can be an attractive source of income, but it’s not without risks. Credit spreads – the difference in yield between the high yield benchmark and 10-year treasuries – are closely watched by investors as a measurement of risk. In March 2020, spreads pushed out to in excess of 10% as treasuries rallied and high yield sold off; more recently, that number stood at 2.39%, near 10-year lows. Those spreads are subject to widening as investors continually reassess market and economic conditions.
Interest rates are another potential concern. While the Fed has committed to keeping short-term rates low for the foreseeable future, investors have continued to express concerns over future inflation and yields on the 10-year have risen well off of last year’s low, up to over 1.6% from below 0.7% in April 2020. Rates seem likely to move higher as the economy picks up, but that may not be all bad for the asset class as better growth can make it easier to amortize debt.
Not all high yield is the same. Dependent upon an investor’s risk appetite and the macro economic environment, a combination of fallen angels and low volatility can offer a more compelling risk/return profile than the high yield benchmark.
1. Bloomberg, as of 3/31/21 for period 12/31/16-3/31/21. Fallen angels represented by ICE BofAML US Fallen Angel High Yield Index (Ticker: H0FA); Low volatility high yield represented by S&P High Yield Low Volatility Corporate Bond Index (Ticker: SPUSHLVT); High yield represented by ICE BofAML US High Yield Index (Ticker: H0A0). Beta is calculated using monthly returns from 12/31/16 to 3/31/21. Past performance is not indicative of future results, which may vary. It is not possible to invest directly in an index.
2. Bloomberg, as of 3/31/21 for period 12/31/16-3/31/21. Fallen angels represented by ICE BofAML US Fallen Angel High Yield Index (Ticker: H0FA); Low volatility high yield represented by S&P High Yield Low Volatility Corporate Bond Index (Ticker: SPUSHLVT); High yield represented by ICE BofAML US High Yield Index (Ticker: H0A0). CAGR and drawdown are calculated using historical monthly returns from 12/31/16 to 3/31/21. Past performance is not indicative of future results, which may vary. It is not possible to invest directly in an index.