risky investment

Much has been written about today’s prolonged low interest rate environment and how it has prompted many investors to seek out riskier assets in an attempt to generate a return that exceeds inflation. One big beneficiary of this trend has been high yield. This year through the end of September, $38 billion has flowed into high yield mutual funds and ETFs, and last week, Russ cautioned that high yield was looking expensive.

Most investors are aware that high yield bonds have greater credit risk than many other fixed income sectors.  But what might be less appreciated – especially by investors who are new to high yield — is how challenging high yield liquidity can be at times, and how rapidly high yield bond prices can fall in a deteriorating market.

Take a look at the chart below. It’s a six-month snapshot of the 2008 financial crisis, and it illustrates how bid/offer spreads on high yield bonds may widen as the market deteriorates. The dark blue line shows the market value of the Barclays US Corporate High Yield Index.  The light blue line shows the average bid/offer spread of bonds in the high yield market.  Notice how the market sell-off was accompanied by rising transaction costs for high yield securities.

hy-blog-chart-600x351

Investors also need to understand the high yield market’s “equity-like” characteristics. For instance, when high yield sells off, it tends to do so in a “risk-off” market in which other higher risk investments, like equities, are also selling off. This drop in value during a stock market decline can be an unwanted surprise for investors who expect the bond portion of their portfolio to rise in value during a risk-off market and to help shelter the overall portfolio from the impact of a market dislocation.

Let’s look at two examples of this kind of dislocated market: the 2008 financial crisis and the US Treasury downgrade in August 2011.  Over the past five years (October 2007 – October 2012), the correlation between high yield and the S&P 500 has been approximately 0.62.* However, during the onset of the financial crisis from 9/15/08 – 10/15/08 this correlation increased to 0.79.  More recently, in the aftermath of the US Treasury downgrade during August 2011 the correlation jumped to a whopping 0.97 – meaning that high yield and equities were moving almost in lockstep with one another.

What does this mean for investors?  High yield can be a good asset class for building yield into a portfolio, but it does not have the same diversification properties that are often looked for in a bond investment. This is especially true during falling equity markets when such diversification may be desired most. This is not to say that investors should shun high yield as an asset class. Indeed, any higher yielding asset is likely to exhibit similar behavior. Rather, investors should set realistic expectations for yield targets and obtain that yield from diversified sources (e.g., high yield bonds, EM bonds, dividend stocks, long duration US Treasuries or corporates).

In the end, yield is never free.  It is just a question of what risks an investor wants to take and how they construct their portfolio.

*Correlations were calculated using daily observations between the market price of HYG and the S&P 500.

Bloomberg :

Morningstar:

BlackRock :

Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Diversification may not protect against market loss. Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.