A short and long term perspective
From pension funds that invest in 100-year bonds to individuals who focus on monthly income, different types of investors have varying investment horizons. This blog is about the prospect of investing in high yield corporate bonds from a short and long term perspective.
The idea of investing in high yield bonds has become more mainstream, especially with the rise of several high yield bond exchange traded funds (ETFs). These ETFs mitigate idiosyncratic risk (i.e. specific to the issuer) by providing investors with low-cost exposure to well-diversified baskets of high yield bonds. For illustrative purposes, this blog examines the Bloomberg Barclays US Corporate High Yield Total Return Index (High-Yield Index). DWS’s forecast implies that there is a positive short-term outlook for investing in the High Yield Index, and in the long term, investors worried about high asset valuations and impending volatility can be reassured by the resilience than the High Yield Index exhibited through the worst financial crisis in recent memory.
What can investors who have a short-term view (i.e. one year or less) expect today from high yield bonds? To answer this question, we need to discuss our expectations for some of the main factors that affect bond yields, namely: downside, carry and yield in price due to changes in interest rates and spreads.
Roll-down yield characterizes the yield that investors receive as bonds age and “roll” along the yield curve. To minimize the complexity, we will not quantify the roll-down yield but rather note that it is positive in the current environment of the rising yield curve.
Carry is the next component of the comeback. To simplify, we use worst-case performance (YTW) as a proxy for the carry of the High-Yield index. The rough carry that investors should expect to gain on the High Yield Index is its current YTW of around 6.5%.
Price performance is affected by duration and the trajectory of interest rates and spreads. The High Yield Index has an option-adjusted duration of approximately 3.9%, which means that for a 1% increase (decrease) in yield, the price should decrease (increase) by approximately 3.9%. . DWS’s forecast for the next twelve months (from September 2018) implies that interest rates and spreads will deviate from their current levels. The table below summarizes our point of view:
|Interest rate or spread||Current levels3||Firm forecast||Implicit change from current level|
|2-year cash flow||2.90%||3.00%||0.10%|
|10-year cash flow||3.24%||3.25%||0.01%|
|Cash at maturity equivalent to 3.9 years1||2.98%||3.06%||0.08%|
|High yield spread2||3.31%||3.70%||0.39%|
DWS forecasts imply around 39 basis points (bps) of widening spreads and 8 bps of rising interest rates to 3.9 years (which corresponds to the duration of the High-Yield index). Widening spreads and rising interest rates have a negative effect on bond prices. Given the duration of the High-Yield Index, the variation in spreads and interest rates implied by DWS forecasts indicates that price movements should have an effect of around -1.8% on returns. of the index.
Adding up our price carry and return estimates, we think investors could potentially expect to earn around 4.7% (i.e. 6.5% – 1.8% = 4.7%). %) on high yield bonds over the next twelve months, and this estimate does not account for a positive roll-down yield that investors should also receive. Therefore, in the current low interest rate environment, high yield bonds may be attractive to investors looking for yield.
In the long run, the focus is on risk-adjusted return, as short-term price movements due to spread and rate volatility become less significant. Therefore, the decision whether or not to invest in the High Yield Index is best influenced by examining its historical performance.
According to a Deutsche Bank default study from April 2016, during the financial crisis, the maximum default rate for high-yield loans did not exceed 14%. As a result, high yield bond indices fell only 33% before starting to recover. How did these declines affect long-term investors who bought high yield bond ETFs before the financial crisis? To get an idea of the answer to this question, we can look at the total return of the High Yield Index and compare it to the total return of the stock market over a ten-year period that includes the financial crisis (i.e. say from August 2007 to August 2017).