The Covid 19-driven selloff created immense volatility and dislocations across fixed income markets. As investors de-risked their portfolios and sought liquidity at nearly any price during the selloff in March, opportunities were created for longer-term investors. Today, even though risk sentiment has improved in markets, we believe that the fundamental outlook remains somewhat uncertain, as the economy, by and large, remains disrupted and the economic fallout from the government lockdowns has been severe. Throughout the month of May, we saw steadily improving news on the virus and economies have begun to open again. This evolution has been accompanied by immense monetary and fiscal stimulus. Even as the world remains quite uncertain, we think there are opportunities for investors in spread assets in fixed income. We believe investors may be able to enjoy considerable price return and earn carry without needing to own the riskiest assets.
High/mid-quality spread assets attractive today
Today across fixed income, yield spread levels to comparable U.S. Treasury maturities are still near historically wide levels (see Figure 1). However, we think the opportunity today resides more in high and medium-quality spread sectors than in the riskiest assets, or in rate-heavy universes, such as the one defined by the U.S. Aggregate Bond Index. As displayed in Figure 1 below, the vast majority of the yield in corporate indices comes from spread risk today. Across all ratings cohorts, more yield comes from spread than from the risk-free component than we’ve seen historically. While spreads are also high in the Aggregate Index, less yield comes from spread and more from interest rates, which of course are historically low at present.
What’s happened in the past when spread makes up the majority of the yield in these indices? High and middle quality assets benefit. On average, the forward one-year spread change in investment-grade corporate bonds is nearly 70 basis points (bps) tighter when spread/yield is above the 90th percentile; BB high yield spreads can tighten by as much as 125 bps in an environment where spreads are a large percentage of yield. At the other end of the spectrum in the rate-heavy Aggregate Index, spreads are tighter but by a competitively small amount—only 23 bps.
So, if spreads are so attractive—why avoid the riskiest and highest yielding assets? Isn’t there more return potential in the higher-yielding parts of fixed income? Perhaps, but we think that the risk/reward favors higher and medium-quality assets at this point in the virus progression and ensuing economic damage, particularly in certain industries and leveraged structures with uncertain levels of future cash flow. And, importantly, we think that the return potential of these assets is good enough that one can be satisfied with the returns available and that chasing excessive risks isn’t required to achieve attractive returns.
Optimizing risk/return through hypothetical portfolios
To illustrate this point, we examine three hypothetical portfolios. The first is a high-quality portfolio consisting of investment-grade corporate debt, the mid- to high quality-rated securitized assets and the “right industries” in the High Yield market. The second portfolio consists of a wider mix of assets, going further down the capital structure, but avoiding the riskiest assets, and the last portfolio was designed to be riskier and would own a portion of the riskiest assets.
In Figure 2, we look at the historical yields of these portfolios, and it’s clear that the middle quality portfolio offers an attractive yield relative to history. The yield offered today in this middle portfolios is competitive with what the riskiest portfolio has offered through time. In other words, to achieve an attractive yield, relative to recent history, one doesn’t need to reach down-in-quality today.
The core of our argument, however, is that total returns may be quite attractive today for some of the higher yielding, but better quality, or industry-specific, sectors. In Figure 3, we look at price return potential. Here, to estimate price return, we assume that spreads tighten to their average level over the last 12 months and assume that yields stay constant. (We also conservatively assume that the tightening happens immediately and that investors then receive the new, lower yield for the rest of the year).
The hypothetical total returns are impressive for all asset allocations under these assumptions, but we think it’s noteworthy how large the absolute return potential and yield are for the portfolio option not owning the very highest yielding asset-classes in the riskiest portfolio. The less risky two portfolios are meaningfully lower in our measure of left tail risk; we believe they offer a safer return stream. Still, even if there is no price return (if risk premia stay high and economic concerns remain for longer than anticipated), yields are still quite attractive in middle-quality assets.
These returns may also be attractive when looking across the capital structure, even looking at equities. In Figure 4, we look at what the price return of the S&P 500 would be were it to return to its average price over the preceding one year. This measure is analogous to the price return potential figure we show in the Figure 3 above. Given the sharp rally in equities in April and May, the index would actually be lower in price if it were to return to its one-year average. This rally was so sharp that this revert to average metric is at its worst point since at least 2010—the bar for a rapid rally in the short term is rising. Of course, equities can still go up since they don’t have the upside cap that we see in fixed income, so mean reversion doesn’t define upside perfectly. The juxtaposition of the equity and spread price return potential figures flatters the upside available in the right parts of the spread market. We think the potential returns in spread assets means that investors don’t need to go down in quality to find a good return these days.
Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is Head of the Global Allocation Investment Team. Jacob Caplain, Director, is a member of the Fixed Income Portfolio Management team focusing on portfolio construction, analytics, and emerging markets fundamental research.