For real-time updates, do join our:
- Telegram Group: The InvestQuest
- Whatsapp Broadcast: Just send “Hello IQ” to +65 8840 2520
Difficulty: Advanced
1) High Yield bonds have credit ratings of BB+ and below. They can have a high default rate during crises.
During the 2008/09 crisis, 14% of High Yield bonds defaulted over the two years. On the other hand, less than 1% of Investment Grade bonds defaulted over the same period.
3) Despite the high default rate, investing at peak credit spreads (i.e. when High Yield bonds were at its cheapest) in 2008/09 would have netted you a great return
Credit spreads peaked at around 19% in 2008. If you’d managed to: 1) invest at those peak spread levels via a 2) diversified high yield portfolio, 3) while experiencing a cumulative default of 14% in 2008 -2009, you could still have netted a cool 24% return (19% x 2 – 14%).
4) But tough to know when credit spreads will peak. Instead, determine what credit spread level you find attractive enough.
Backtests reveal that investing at 8% credit spreads in 2008/09 would have gotten you a decent 8.4-9.5% annual return over a 3-5 year period.
5) For the current crisis, IQ is keen to enter the High Yield markets at 8%/higher credit spreads, with a diversified portfolio and a 3-5 year horizon
Take a look at bond default rates from investment grade to high yield
“The time to buy is when there’s blood in the streets”
– Baron Rothschild
Are the streets bloody enough? No one disputes that the best time to invest is when financial markets are distressed and security prices are heavily discounted to fair value. The key question however, is determining whether the streets are sufficiently bloody to pull the trigger.
Maybe they were in mid-March… I believe we did encounter such a scenario in mid-March when bonds from fundamentally good companies were sold off heavily, akin to throwing the baby out with the bathwater, as investors rushed to raise capital to cover margin calls.
Investment-Grade (IG) Bonds sold off by more than 20% within a month, using the iShares iBoxx $ Investment Grade Corporate Bond ETF as a reference. This made little sense to me, as according to rating agency S&P, the actual default rate of IG rated bonds was less than 1% cumulatively across 2008-2009 (see table below).
But for High Yield credits, risk of default is much more tangible. This is particularly so during a downturn. Cumulatively across 2008-09, we witnessed default rates of approx 14% for such bonds that are rated BB+ and below.
The High Yield default risk is very tangible. But what if you invested at peak credit spreads in 2008?
With great risk comes potentially great returns. Credit spreads peaked at around 19% in 2008 (image below). If you’d managed to: 1) invest at those peak spread levels via a 2) diversified high yield portfolio, 3) while experiencing a cumulative default of 14% in 2008 -2009, you could still have netted a cool 24% return (19% x 2 – 14%).
We didn’t even add in the risk-free rate. Theoretically, we should add in the risk-free rate too in our return calculation as bond yield = risk-free rate + credit spread. But we’ve excluded it to be more conservative.
Other conservative assumptions: 1) no credit spread tightening during the period, 2) the unlikely event of zero recovery values on the defaulted bonds.
US High Yield Default rates and Credit Spreads since 1990
Some words from the legendary Howard Marks
…just a word on market bottoms. Some of the most interesting questions in investing are especially appropriate today: “Since you expect more bad news and feel the markets may fall further, isn’t it premature to do any buying? Shouldn’t you wait for the bottom?”
To me, the answer clearly is “no.” As mentioned earlier, we never know when we’re at the bottom. A bottom can only be recognized in retrospect: it was the day before the market started to go up. By definition, we can’t know today whether it’s been reached, since that’s a function of what will happen tomorrow. Thus, “I’m going to wait for the bottom” is an irrational statement.…
So if investors want to buy, they should buy on the way down. That’s when the sellers are feeling the most urgency and the buyers’ buying won’t arrest the downward cascade of security prices.
Quoted on 6th April 2020 by Howard Marks, Oaktree. Extracted from Oaktree Corporate Website
Now, the challenge is: What level of credit spreads would I be comfortable entering High Yield markets at?
First, where do I think credit spreads will peak?
The InvestQuest’s View: Personally, while I believe the upcoming recession may be worse than 2008-09, the bond market will be better supported this time around with government stimulus and better capitalized banks which are more willing to facilitate lending.
So in my opinion, credit spreads could possibly peak somewhere between the 10% level that we saw at the height of the dotcom bubble & 9/11 attacks and the 19% level during 2008-09.
US High Yield Credit Spreads since Apr 2007
Second, what do historical backtests show if I’d invested when credit spreads hit 8% and hit 10%?
Historical backtests to check returns if you’d invested at 8% and 10% credit spreads. And as we can never catch the bottom, I ran some backtests to calculate the type of returns you would have gotten across a 6-month, 1-year, 3-year and 5-year horizon, had you invested in a High Yield Bond ETF when credits spreads first hit 8% on 14th March 2008 and 10% on 29 September 2008.
High Yield Bond ETF total returns assuming purchase when credit spreads first hit 8% in 2008-09 crisis
High Yield Bond ETF total returns assuming purchase when credit spreads first hit 10% in 2008-09 crisis
Finally, what level of credit spreads would I be comfortable entering High Yield markets at?
The InvestQuest’s Plan: 8%, and averaging down as credit spreads continue to widen. The InvestQuest plans to adopt a 3-5 year horizon and be sufficiently diversified within the High Yield sector. The longer time horizon would give me much more leeway to look past the elevated level of defaults that we expect to hit in the short-term. If history provides an accurate guide, we could expect 8% to 12% annualized returns from High Yield at this point.
1 Trackback / Pingback