Could high yield bonds become a more important asset over the next decade?

When everything looks expensive or volatile, where can investors find yield and diversification? This is the question every portfolio constructor faces after such a turbulent April. On the equity side, valuations have returned to their highs in terms of price/earnings ratio, after their ‘Liberation Day’ declines. The earning yield for US equities is back to 4.2%, which compensates neither USD cash at 4.3% nor the yield to maturity of 10-year US bonds (4.3%). Duration risk itself is poorly rewarded – as seen in the previous figures. Is there any hope?

One asset class still offers compensation for the risk its holders incur: high yield (HY) and, more generally, the broader credit world, such as crossovers or fallen angels. With ‘all-in’ rates of around 7.8%, yields not only compensate for cash but also for the associated interest rate risk – high-yield indices' duration is around 6.5 years, two years less than a US Treasury 10-year bond. As mentioned previously, the diversification previously drawn from bonds during the first part of last year has evaporated like snow in the sun since the US elections. The equity world also appears to have reached prohibitively expensive levels again.

This issue of Simply put asks if the high yield credit world could (surprisingly) provide a solution?

Read more: Will Donald Trump’s fiscal plan work?

A look at 10 years of performance

Before diving into an expected returns analysis, examining historical performance can help explain more recent performance and, possibly even, help us better prepare for the future. Figure 1 shows the rolling annualised returns of different US asset classes: equities, high-yield bonds and US Treasury bonds. The risk premium hierarchy is respected over the long term: bonds show an excess return of about 2% (compensation for duration risk), high-yield bonds an excess return of 4.5%, while equities show excess returns slightly above 5% on average long-term (albeit reaching 15% in recent years!). While this relationship is consistent with Markowitz's intuition that more risk = more return, our study of the fluctuation of these returns emphasises that this relationship has some important caveats:

• It's not stable over time. Between 2005 and 2008, for example, the 10-year excess returns of the three asset classes were very similar and didn’t reward relative risk-taking; from 2009 to 2012, the shock of the Great Financial Crisis was such that it maintained this inverted order relationship over a long period, even placing high yield and equities in negative territory at times
• It tends to mean-revert. When the relationship linking return and risk is challenged, it tends to return to normal in subsequent years. Worse still, like physical ‘action-reaction’ phenomena, any excess tends to result in a correction that brings returns back to their long-term averages. The graph clearly shows the excess performance of equities during the tech bubble and their return to the mean in subsequent years, through three years of negative performance. Since 2018, US equities have exhibited a similar anomaly, raising the question of a possible mean reversion. Note, US equities have never remained in such high positive excess territory for as long, underlining their recent dominance
• The more volatile an asset is, the greater the deviations around the mean excess return. Thus, equities intuitively go through more cycles of over and underperformance, while such deviations are lower for high yield and even more so for sovereign bonds (of average duration).

FIG 1. Rolling 10-year returns above cash rates¹

What about today?

While equity returns appear historically abnormal (bond yields present an equally striking anomaly), studying their relationship with carry over cash rates can guide the present and future situation. Figure 2 links excess carry over cash rates and performance for the following 10 years, across the same period as shown in Figure 1. This graph clearly shows that carry and performance are historically linked. The slope of the regression line varies by asset class: equities multiply the carry (x1.27) while high yield tends to retain only half of it; the ‘pull-to-par’ of bonds caps the yield effect in comparison to equities. Yet, this difference in slope is not the central point here, it also shows that more carry means more future return, while less carry signals the opposite. This is quite intuitive. Carry is generally an inverse indicator of valuation, similar to using the earnings yield (EY) for equities (the inverse of PE). The current situation can be described as follows:

• With carry above cash close to zero, the expected 10-year return for US equities is in the vicinity of 1%
• On the high yield side, the situation appears more promising. Over the last decade, high yield returns remained below their long-term average, while today the asset class's carry seems attractive compared to equities.

To put it differently, high-yield assets with access to leverage could benefit in the future. That said, the asset class requires certain selectivity or strong position diversification, as default risk must be considered in assessing the overall risk of these assets.

Read also: Bonds, ETFs or CDS – in high yield, which is more resilient to liquidity shocks?

FIG 2. Rolling 10-year returns above cash rates vs high-yield spreads against cash rates and earnings yield above cash rates²

Investment implications for multi-asset investors

Since launch, our strategies have invested in credit to derive yield, better risk control and diversification throughout the cycle. The situation today is no different, and our risk models lead us to maintain significant exposure to this asset class through CDS (credit default swaps) on indices in the US and Europe. Our trend signals place the asset class in neutral territory, while our macro signals are marginally overweight the asset class. Exposure to high yield thus still seems opportune at this stage of the cycle.

Simply put, the high yield world could regain portfolio prominence in the coming decade, given the asset class's carry in the US.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Our latest growth nowcaster signals have declined, particularly in the US and China, due to different factors. In China, export-related data weakened, while in the US, monetary conditions have tightened over the past few days 
• Our inflation nowcaster remained flat with a marginal decrease in the US
• Our monetary policy indicator also remained flat, except in China, where it surged due to an increase in export data.

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).