We can see that from a statistical perspective, it is unlikely that HYG will go much lower. Most drawdowns stop in the negative 7.5 percent region.
Except when they don’t. That’s when we get the downside of “equitylike behavior”: equitylike losses.
So the trade-off today is to buy into something that is relatively cheap, but absolutely expensive, for an extra 100-150 bp of yield now being offered.
Opportunity Vs. Risk
In balancing this opportunity versus the risk, we believe a trend-following methodology can be useful. Our research shows that roughly 60 percent of high-yield return comes from yield, and 40 percent comes from capital appreciation (or, depreciation).
For income, we’re buying the yield. The volatility of repricing as companies default and credit spreads widen, however, is the risk we must control.
We believe that by using a simple trend-following methodology, we can identify those periods of time when it is safer to tap into the income stream without risking significant capital loss from price depreciation.
Today our momentum model still indicates a negative trend in high yield—a signal it has given for more than 12 months. Consistent with our core philosophy that capital preservation is a key objective, we are avoiding high-yield bonds until we see positive momentum return—which, according to our models, may actually be just around the corner.
Newfound Research LLC is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in August 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research LLC, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.