3 Reasons To Underweight High-Yield Debt

November 11, 2014

Forced Into Unfamiliar Territory

Our third argument in favor of paring back high-yield exposure is based perhaps more on experience and is less data-driven. Simply put, there are many individual and institutional investors today who own high-yield debt who didn’t prior to 2008. This phenomenon was recently and aptly characterized by the Financial Times as “overenthusiastic buying by uninformed investors.”

Prior to the financial crisis, there existed an entire investor cohort, made up primarily of retirees, that invested almost solely in U.S. Treasurys and agencies, FDIC-backed bank CDs, and perhaps some very high-quality investment-grade debt. These cautious investors were intent on clipping coupons in order to meet a predetermined income mandate. Risk and volatility of return were not part of their investment equation.

A Vulnerable Class Of Investors

The Fed’s plan to save the economy by driving down interest rates and forcing investors outward on the risk curve has impacted this investor class perhaps more than most. In 2006, a 10-year U.S. Treasury note yielded 4.7 percent. Today it yields 2.3 percent.

The BAML US Corporate Bond Index had an effective yield of more than 5.5 percent in 2006. Today that yield is barely above 3 percent. Retirees dependent upon an investment portfolio to supplement Social Security or a company pension have seen their income from bond interest cut in half.

Investor_Income_Options

Not only is the income profile different, but so is the risk. Look at what happened between 2007 and 2008 at the onset of the crisis. Below we compare returns on government bonds against those on investment-grade corporate and high-yield bonds. Notice the dramatically different return profile of Treasurys in 2008 versus non-Treasurys.

 

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