In our work timing if not everything, is certainly a good part of the performance and therefore as for equities or even as for the choice of which part of the yield curve to overweight, also for high yields an analysis is necessary.
So is this the time to buy High Yield? the immediate answer is no, but below I will show you why.
High Yield bonds are a riskier bond part because they contain bonds of companies with the highest probability compared to the rest of the bond market, of defaulting on the debt or part of it. These are BB BBB rated bonds and similar and therefore the yield in this sector is very attractive, but it is so for a specific reason, the risk that an investor takes on.
High Yields returns vary over time, how? The variation is due to the supply-demand of paper. Periods of low yields are usually signs of euphoric markets because there is a lot of demand for HY bonds because investors perceive that there is no default risk. HY yields are compared to those of better quality and usually the “spread” is towards government bonds, US or EU depending on the geographical focus.
The tighter the HY-US (or HY-EU) spread, the closer HY yields are to government bonds, the more we are in the presence of euphoria and complacency in the markets and the closer we are to a market maximum (equities and bonds).
The wider the spread (investors sell HY en masse) the further HY yields move away and the more we are in the presence of markets under stress and at a certain point to a minimum.
Where are we today? To understand it precisely, let’s take a graph directly from the website of the Federal Reserve of Chicago in which the financial situation is shown through an index, the “National Financial Condition index” or NFCI that you can see at the link, of which I report the graph here for convenience.
https://www.chicagofed.org/research/data/nfci/current-data
We will then compare this index with two graphs of two different historical moments: 2021 and the current one. In the graphs you will see two ETFs, HYG which is the American ETF for American High Yields, but also the IHYG which is instead the twin but European ETF.
Well, the last peak of expansive US financial conditions was in June 2021 which was followed by a restrictive period until March 2023 and then reversed the cycle until today. With a lag of about three months, the stock markets followed these cycles, going to a minimum in October 2023 and then resuming the rise.
What happened to High Yield in the same period?
Since the peak in 2021, the two ETFs have lost between 13% and 15%, while from March 2023 to today they have gained 8% for US and 4% for EU respectively.
We are therefore also monitoring High Yield to include them in our bond portfolios, but now as demonstrated, it is not the time, unless in the case of dividing the entire capital allocated to this asset on multiple investments over time, trying to leave the largest part for when the time comes.
Historically, High Yield is the riskiest part of the bond market. Risky means that this sector has a relatively high level of default on debt, which is why the returns of this sector are higher.
But in recent years, HY has undergone a metamorphosis, in reality the entire bond sector, but let’s focus on HY.
Not all HY is the same and even in this sector the rating makes the difference going from B to BBB or in the riskiest case even without a rating.
Thanks or because of the flood of liquidity that occurred after 2011 in the USA in particular, this liquidity was available to banks but above all to private equity firms.
These therefore, in order to earn fees, must always create new vehicles, and after having exhausted the space in the equity sector, they have moved more massively to the bond sector, thus going into the most profitable sector and where there are greater margins both in terms of returns and therefore fees. In fact, it is difficult to command a fee structure of 3% management and 25% performance (it is not the standard but an example) on a traditional bond fund where returns vary between 4% and -20% (in 2022).
That kind of fees is justified for a vehicle that has returns above 10% and this is the case, potentially, of High Yield.
Therefore, by private equity companies taking cards away from the sector, this has therefore produced more effects:
It has cleaned up the high yield bond sector of a slice, usually the least reliable, of bonds and/or issuers, in fact further segmenting the bond sector; this has led to a higher quality of the high yield sector as the riskiest part is no longer present (generalizing); on the other hand, a new asset class has been created, the private market/private credit which allows for returns similar to stocks with a similar risk, but in a different asset;
the reason why this new asset exists is to provide the possibility of alternative returns to those who, for example, have a mandate to invest only in bonds; the greatest marginal risk has therefore moved to private credit, making this sector the new “subprime”. The term now has an ominous connotation but in reality it is totally neutral and will not necessarily lead to the same consequences; for both high yield and private credit, the entry signals always refer to the NFC index.
This is why today it is generally safer (in terms of default of the underlying assets) to invest in high yield.
To demonstrate what has just been described above, I am attaching a graph showing the size of these sectors. You can see how the growth of assets in Private Credit (green bar) from 2001 to 2023 has been constant and at times exponential in some years, while the size of high yield assets today is even lower than in 2015. From 2015 to 2023, the growth of private credit has been exponential, a sign that the decrease in the size of the high yield sector is exactly a linear consequence of the further segmentation through the creation of the Private market.
I hope this further part on high yield is of interest to you. This does not mean that we will now invest in high yield. But it certainly means that it is a better asset class than it once was, perhaps with slightly lower but more stable returns and that, when there is a buy signal (not present now) we will not be shy in allocating to this asset class.
