Alternative US High Yield Approach: Conservative but Attractive
by Patrick Oberhaensli, on Sep 28, 2020 4:41:00 PM
In this article, we will discuss the opportunity to apply an advanced approach to the US high yield market. A long-only passive investment would not earn enough return given the risk taken, so it is necessary for investors to go beyond a long-only investment in order to obtain a much better risk-return balance. Therefore, our objective in this article is to present a conservative (but without constraints) type of management of high yield assets.
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An Illustration of the Conservative Risk-Based Approach
Considering a new and innovative technique to deal with high yield credit spreads, the following low beta profile could be established:
For the period starting end of June 2007 up to the 8th of May 2020, including specific costs, we have following table for the US High Yield Long/Short/Out low beta
The annual average return is more than 425 basis points above that of the passive long-only portfolio while at the same time the volatility is reduced by more than 2.5 percentage points. This is a consequential improvement that is also reflected in the Sharpe Ratio of 0.89 – a value that increased by 0.70 or in other words, more than tripled! The (complete period) maximum drawdown, calculated on daily and not monthly returns, is about 3 times smaller than that of the reference, allowing this approach to be considered “conservative”.
The low (but positive) beta is consistent with the rather low but positive performance of the passive long-only portfolio.
Equities as a Key Driver
A key input our alternative strategy is the risk information from equities. For example, in the capital structure when bonds are priced as junk bonds, then their risk is significantly closer to… equity risk. It should be noted that although these bonds might also be rated as junk bonds, it is not necessarily always the case since price movements are typically quicker than rating changes.
There is high quality information to be extracted from there, given the anticipatory nature of the equity developments. This can be clearly illustrated in the situation of March 2020 which was the worst month, in years, for a long-only investment. Equities also had a very bad month during this time – but the drawdown started after a peak in February 19th for US large caps. There was a high probability that the credit spreads would widen significantly – especially in the junk bond segment, and they did, after March 6th.
That situation caused many investors to go out of the market or even better, to go short junk bonds, which is possible through different techniques.
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Interest Rate Risk
Another dimension that needs to be considered, at the same time as equities, is that of interest rate risk. To be precise, we are referring to the credit risk free interest rate component of junk bonds – upon which the credit spread represents an add-on yield for the… credit risk and other relevant risks.
The basis in USD to evaluate the (credit risk free) interest rate risk is the US Treasury notes respectively bonds with the same maturity. In other words, the analysis of the interest rate exposure is of paramount importance. While credit spread widens (very) strongly, it is likely that the interest rate component, the credit risk free yield, diminishes due to the “flight to quality”.
This makes it difficult to isolate the credit risk. For that purpose, the investor would need to go short US treasuries. In this case, the US treasuries would rally and therefore bring losses to the short position. These losses would need to be immediately compensated when dealing with futures (which is usually the case). The risk being managed with margin calls.
A long/short/out strategy for US high yield allows investors to generate substantially higher returns with much less risk than that for a passive long-only investment. At the same time the diversification potential is clearly increased and a proper allocation in a multi-asset portfolio can then be justified.
EVOLIDS FINANCE LLC, Disclaimer:
- This content is not intended to be a solicitation nor an offer
- The preparation of the information provided herein is done with a high level of care. Nevertheless, errors are possible