Executive Summary
Based on the fundamental factors that drive equity and high-yield returns, the expected 10-year returns for each asset class are in line with each other.
Since 1984, high-yield has exhibited less volatility, less downside deviation, and fewer negative returning months compared to equities. Additionally, high-yield has shown shallower drawdowns during periods of significant market distress.
High-yield’s shallower drawdowns paired with higher relative monthly distributions present significant market timing option value.
My estimate for EPS growth is lower than current expectations, and I assume P/E reversion to the mean when calculating expected equity returns. The biggest risks to this thesis are EPS growth exceeding estimates and low-to-no P/E reversion.
This tactical strategy may not be suitable for all clients due to factors such as taxes, portfolio objectives, and client-specific behavioral risks.
Investment Principles and Definitions to Keep in Mind
Before we start, some investment principles to keep in mind during the entirety of this discussion.
Over very long-time horizons, equities outperform fixed income which outperforms cash. This is necessary for properly functioning capital markets.
If two asset classes have similar return expectations over the same time-horizon, they must have the similar risk.
If two asset classes have similar return expectations over the same time-horizon, but have different levels of riskiness, then a tactical opportunity exists. Go long the less risky asset and short the riskier asset.
With these principles in mind, I believe that corporate high-yield fixed income and US large-cap equities have similar 10-year return expectations. However, high-yield is less risky than equities, presenting a tactical opportunity.
To reduce word count, I'm simply going to refer to corporate high-yield fixed income as "high-yield" or "yield", and US large-cap equities as "equities". The following investments served as representatives for the analysis, conducted over the stated time horizon:
Vanguard 500 Index Investor (VFINX) – “Equities”
Vanguard High-Yield Corporate Inv (VWEHX) – “High-Yield”
Time Horizon – 12/31/1984 - 3/15/2024. Analysis starts on 12/31/1984, when VWEHX started pricing daily (was previously bi-monthly). I did this so it didn’t artificially suppress volatility and skew risk metrics in support of high-yield.
Let's begin.
Expected Returns
Although it's a well-known adage, investors often forget the fact that past performance is not indicative of future results. Nonetheless, as investment managers, it's our responsibility to assess specific asset class returns, risks, and correlations with other asset classes to make portfolio management decisions.
Homing in on returns specifically, there are a few ways portfolio managers get their expected return numbers:
One is by estimating returns based on the fundamental drivers of an asset class,
another is by getting estimates to a third-party provider, and
the final, and least sound method, is by simply extrapolating past returns into the future.
Since I'm not lazy and run my own firm, I'm going to opt for option #1.
Fundamental Return Analysis
So getting to it, let's discuss the fundamental return drivers for equities and high-yield.
The fundamental drivers of forecasting equity returns are it's,
going-in dividend yield,
expected Earnings-Per-Share (EPS) growth,
and expected change in P/E ratio over the holding period.
And for fixed income,
the going-in risk-free rate,
and going-in credit spread (its option adjusted spread),
adjusted for the expected probability of default,
and the expected recovery rate if a default occurs.
Estimating Equity and High-Yield Returns
With this framework, when estimating equity returns, we can easily see that the current dividend yield is 1.26%.
When estimating future earnings growth, and using Robert Shiller's data set ending 12/31/2023, I took the past rolling 10-year average of earnings growth since 8/31/1971, when the U.S. Dollar became a fiat currency, to act as an estimate. This comes out to 6.32%.
Finally, using the same data set and time horizon, I took the average P/E ratio (20.01) and amortized the current P/E ratio (26.50) to the average over a 10-year time horizon . This shakes out to -2.77%.
Putting it all together (1.26% + 6.32% - 2.77%), this comes out to a 4.81% forward return expectation for equities.
Now for high-yield.
The 10-year treasury rate is currently 4.30%, and the BB option adjusted spread is 1.94%. Multiplying 6.24% by 1 minus the cumulative expected default rate over 10-years (12.09% for BB rated debt) comes out to a 5.49% expected return for high-yield. For simplicity, I excluded a recovery rate assumption but including one would increase high-yield's expected return.
So using reasonable assumptions, equities are expected to return 4.81% and high-yield is expected to yield 5.49%.
This provides a decent 0.68% spread for high-yield outperformance but to provide a margin of safety we'll assume both asset's expected returns will be roughly the same over the next 10 years.
Expected Return Scenario Analysis
Now of course, actual returns will vary widely from expectations as nobody really knows what's going to occur in the next 10 years. Hence, why it's important to perform a scenario analysis of your assumptions.
In my view, the two biggest and uncertain risk factors to relative performance are total equity returns and high-yield spreads over time, so let's do a deeper dive on each assumption.
Equity Return Assumptions
While I don't put much weight into absolute, non-adjusted historical returns when making future return assumptions, the daily rolling 10-year total returns since 12/31/1984 have averaged 10.18%. A far cry from the 4.81% expected return we calculated earlier.
So, since that assumption seems crazy, it may be useful to see what other professionals think.
Every year, J.P. Morgan releases their annual long-term return expectations for a variety of asset classes. These projections are as of the end of the third quarter of the preceding year. So the 2024 Long-Term Capital Market Assumptions are really made as of Q3 2023.
As of Q3 2023, J.P. Morgan published that it expects large-cap equities to return 7.00% over the next 10-15 years. Since that time, the S&P 500 has returned 20.66%. Meaning, according to J.P. Morgan, the S&P 500 has pulled forward approximately three-years worth of returns, which should decrease their long-term assumption by 2.07%. If you subtract 2.07% from 7.00%, that gives us 4.93%. Which is slightly higher than what I'm assuming, but certainly within the ballpark.
So given JPM's team of experts that they threw at crafting their long-term assumptions, their expectations, adjusted for performance since their publication, essentially imply the same equity return.
So yeah, my assumption looks crazy versus historical results, but are roughly in line with J.P. Morgan's.
Credit/Option Adjusted Spread (OAS) Assumptions
When looking at current spreads versus spreads over time, I thought it would be appropriate to provide a range of 1.50% - 2.50%. Currently spreads are near the middle of that band, at 1.94%.
As you'll see above, it may seem ridiculous to assume an OAS range of 1.50% - 2.50% given an average spread of 3.54% with spread getting as high as 14.68% during the Global Financial Crisis.
However, we want assume what expected high-yield returns would be during "normal times". Yes I put "normal times" in quotes because there's never been a normal time in our investment history.
In addition, periods of significant stress have significantly skewed the average upward, which makes the 3.54% average an inappropriate baseline assumption. This makes the underlying distribution of credit spreads exhibit significant skewness and kurtosis with no reliable mean-reverting property. But, no worries, we tackle high-yield during periods of stress later when we discuss asset behavior during periods of market distress.
If spreads end up materially higher, the speed in which spreads increase will be a major determining factor for high-yield performance. If it's a gradual increase, then this is actually a positive for long-term high-yield returns. However, if it's sudden and sharp, default rates will likely increase as companies won't be able to gradually adjust to higher financing rates.
Scenario Analysis Performed
In my scenario analysis, I provide low spread (1.50%), base spread (2.00%), and high spread (2.50%) scenarios with three different default rates (10%, 15%, and 20%). I then run it for current equity expectations (4.81%) and subsequently two more times, adding 0.50% to equity returns each time.
So starting with equities at our baseline 4.81% return...
...then with equities returning 5.31%...
...and finally with equities returning 5.81%.
If you look at what I believe are the most likely outcomes, outperformance is roughly split, with high-yield edging out equities in 11 out of the 21 scenarios. The average outperformance for when high-yield outperforms is 0.43% and for equities, 0.40%.
The reason I didn't include the following scenarios:
Low Spreads, High Defaults: A persistently low spread should lend itself to lower defaults, not higher. This is because low spreads not only decrease the financing costs on debt, but they’re also typically observed during periods of a healthy economy.
High Spreads, Low Defaults: The same as the previous reason but in reverse, high spreads (and therefore high default rates) are typically during times of high economic distress. Although the Federal Reserve tends to open credit facilities for low-quality companies and engage in Quantitative Easing operations during distressing times to ease credit burdens and alleviate defaults.
As we can see after looking at a variety of different scenarios, high-yield returning roughly the same as equities seems even more like a reasonable assumption.
High-Yield Outperformance isn't Unprecedented
Suggesting high-yield outperformance over a 10-year time horizon seems bold but looking historically, it's not unprecedented for the asset class to outperform equities.
But, giving equities their due, they have outperformed high-yield fixed income over very, very long-time horizons and should continue doing so in the future. This is necessary for properly functioning capital markets.
However, when we narrow our time horizon a bit and look at rolling 10-year total returns, equities haven't always outperformed.
Looking below, the rolling 10-year returns for high-yield began outperforming equities in February 2008 and started underperforming again around February 2013. So if you invested in high-yield at any time between February 1998 and February 2003, you would have outperformed equities and significantly so if you invested between 1999-2002.
After February 2013, you would have only slightly underperformed equities until around December 2018, when equities started significantly outperforming again. This outperformance implies investing in equities during 2008-2009 would have been a winning bet.
Digging Deeper into The 2000 - 2015 Period
Market historians and practitioners understand why this is the case. The 1999-2001 period coincided with the run-up and subsequent bursting of the Dot-Com Bubble, during which equity markets experienced a decline of over 49%. Towards the end of the decade, the Global Financial Crisis occurred, causing markets to fall by over 55%.
Now am I predicting either of these events to occur? No.
Although the latest A.I. craze has elicited Dot-Com Bubble headlines, the comparison isn't justified. We are nowhere near the equity valuation levels today versus where we were during that period and the underlying fundamentals of the A.I. companies in question are far stronger.
Are A.I. and tech companies overall richly valued? Yes. Are they grossly detached from their fundamentals? Somewhat. But, are there signs of The Greater Fool Theory at work? No.
All I'm illustrating is that equities don't always outperform other asset classes over 10-year time horizons, including fixed income. So it's not crazy to think they'll underperform again at some point in the future. Markets ebb and flow.
But! Keep in mind, given a sufficiently long-time horizon, equities will likely outperform.
This is why my argument is for a tactical allocation, not a permanent one.
Although, this decision needs to be made on a client-by-client basis and rolling a tactical allocation from equities to high-yield should be unwound at some point in the future.
Both points will be discussed further in detail. But, before we do, we have to talk about what causes price volatility.
Risk
What Moves Asset Prices?
Why do prices go up and down? It sometimes appears fairly arbitrary and sometimes it actually is. However, in most cases, we can attribute price movement to changes in each asset's fundamental return drivers.
First, high-yield. High-yield prices,
react to changes in the risk-free rate and
changes in the credit spread.
The sensitivity of rate changes on price returns depends on the securities duration. The high-yield fund we've been analyzing has a duration of 3.22. This means for every 1% increase in the effective yield (risk-free rate + credit spread), the security price is expected to drop 3.22%. The same works in reverse, a 1% drop in effective yield increases the security price by 3.22%.
Easy enough, however explaining price movements for equities is a little more complicated.
Digging into the fundamental drivers of equity returns, price movements,
are also driven by changes in the risk-free rate,
but unlike high-yield, are driven by the equity risk premium and,
changes in growth expectations.
First, changes in the risk-free rate are easily observable.
However, calculating changes in the equity risk premium is difficult. You can glean insight based on changes in credit spreads, but it acts as an imperfect proxy. This is because equities can exhibit extreme price levels relative to fundamentals, as was the case during the Dot Com Bubble (when it was theorized that equity premiums were actually negative) and more recently for a handful of non-profitable tech companies and "meme stocks" in 2021. The same applies when equity markets crash, such as during the bursting of the Dot Com Bubble and when we were in the depths of the Global Financial Crisis. Equity premiums can be very large when everyone is panicking.
Basically, equity markets are more susceptible to excessive fear and greed than fixed income markets. Hence, why movements in credit spreads can't fully explain changes in the equity risk premium. This is illustrated by the fact that everyone and their mother knows how to buy a stock, but very few have a clue on how to buy a bond.
Finally, teasing out growth expectations provides even more complexity. Yes, Wall Street analysts provide both top-down and bottom-up estimates, but these estimates are released periodically (monthly or quarterly) and not day to day. When equity markets have already crashed, it doesn't do much good for analysts to revise their growth estimates downward because equity markets are already reflecting lower growth expectations. If companies are blowing up, which subsequently causes markets to fall 50%, analysts revising growth expectations downward will elicit a, "duh".
Because of the unobservable input for expected growth and the observable, but imperfect credit spread proxy for equity risk premiums, you can see why it's so difficult to isolate any independent variable when describing equity price changes. You can only make inferences for why equities are moving, and this becomes even more noisy as you reduce your time frame.
To further complicate things, equity duration is tricky because equities don't have stated maturity date like fixed income securities do. Yes equities, believe it or not, have duration risk because the price you'll pay for a company is influenced by the risk-free alternative.
Most businesses operate under a "going concern" assumption, in which they're expected to stay in business for the foreseeable future. So, from first principals, if a security is expected to last in perpetuity (or at least a very, very long time), it must have a longer duration than one that has a shorter, finite life, all else equal.
So when theorizing which asset class is most likely to perform better during times of market distress, we have to make the following assumptions:
High-yield has a lower duration than equities.
The unobservable expected growth variable for equities increases relative volatility, for better or worse.
Statistically and historically, these assumptions have panned out. Equities have had a higher monthly standard deviation (4.42%) versus high-yield (2.06%) and larger downside deviation (3.34% vs. 2.00%, respectively). Equities have had 165 down months versus 132 for high-yield and high-yield has had an upside and downside capture ratio against equities of 35.68% and 21.87% respectively, pointing to the low beta nature of the asset class.
Negative Compounding and Large Drawdowns (The Risk That Matters)
Now statistics are interesting to look at and can be useful when analyzing securities, however, they shouldn't be the main consideration when assessing risk.
At the end of the day, risk is the probability of not meeting your stated objective. Therefore, from the risk side, negative compounding from large drawdowns is the biggest risk to meeting a stated objective. Returns are the other component, but we've already discussed that ad nauseum.
If an asset falls 10%, you need 11% to get back to even (1% difference). Not terrible. But, if an asset falls 30%, you need 43% to get back to even (13% difference). Terrible. And a 50% drawdown requires a 100% breakeven return. YIKES!
Therefore, avoiding large drawdowns is absolutely critical to meeting client goals.
When looking at large historical equity drawdowns, in which stocks fall by more than 20%, the drawdown of high-yield versus equities favors high-yield. This backs up the assumptions made during the previous 'What Moves Asset Prices' section.
Another reason why this makes sense is that during periods of market distress, credit spreads typically spike but duration risk is offset by risk-free rates falling.
Risk-free rates fall because there is typically a "flight-to-safety" into treasuries and the Federal Reserve typically cuts rates and undergoes open market operations to keep financing rates low and companies afloat. This dynamic has been shown to occur to varying degrees for all periods of market distress observed, with the exception of the 2022 Inflation Drawdown. However, because rates increased gradually instead of suddenly during 2022, high-yield still had a shallower drawdown versus equities.
Below you'll see a series of charts which depict periods when equity markets fell by more than 20% and then recovered (peak-to-trough-to-recovery). Notice how the orange line (high-yield) is shallower than purple (equities) for each period shown.
So yield has historically provided better downside protection during periods of market distress. Because of this, high-yield has significant positive optionality and is another reason why I'm bullish on this tactical strategy.
High-Yield Has Significant Positive Optionality
Most investment managers don’t think intertemporally, they only think “point-in-time”. Most portfolio managers insist on remaining 100% invested in equities for long-term clients despite where we are in the market cycle.
It's easy to see why, after all equities do outperform during a sufficiently long-time horizon, timing markets is difficult to pull off, tactical allocations increase operational complexity, and investing in the highest returning asset maximizes fee revenue.
But, wouldn't it be nice to have some dry powder for when stocks are falling? Allowing you to buy them up at an attractive basis?
I believe so and think high-yield provides that opportunity.
Rolling Down Your Drawdown
As I've shown, equities have had larger drawdowns versus high-yield during periods of market distress. Strategically, this provides a valuable opportunity to perform what I call "rolling down your drawdown."
"Rolling down your drawdown" is when you sell out of a less risky asset to invest in a more risky asset. A Martingale-type investing philosophy, you increase beta at a time when you're being better compensated to take on equity risk or as Warren Buffett would say "buy when others are fearful."
The value of this option lies the basic relationship between price and future expected returns (shown below). I call it the price/return seesaw.
If you agree that high-yield and equities are currently priced to produce similar returns, then this option is extremely valuable. Simply put:
When two assets have the same expected return and one asset falls further than the other, the expected return of that asset is higher than the one that didn't fall as much.
Thus, the positive market timing option when looking at the two asset classes relative to each other. As mentioned at the beginning of this post,
If two asset classes have similar return expectations over the same time-horizon, but have materially different levels of riskiness (i.e., drawdown risk), then a tactical opportunity exists.
Hence, the crux of my thesis.
Enough theory, let's look at this opportunity historically. Below you'll see the total return drawdown of equities versus high-yield.
Again, and even more so when looking at total returns, high-yield has had shallower drawdowns than equities. This makes sense since the high income return component of high-yield automatically allows you to reinvest into the security when its price is falling, averaging down your basis.
Since equities don't pay out as much in income and pay out income less frequently, equities provide less of an opportunity to average down your position in drawdown scenarios.
When analyzing opportunities to roll down your drawdown, I calculated the drawdown difference between equities and high-yield, shown in green below. Underperformance indicates the amount by which equities have fallen further than high-yield and the reverse is true for outperformance.
As you'll see below, there have been significant opportunities to roll down your high-yield drawdown into equities.
A simple hypothetical example to drive this point home. Equities and high-yield are expected to return 6% over the next decade. If equities fall 20% and high-yield falls 10%, then equities are now expected to outperform by 1% per annum over the next 10 years. In this scenario, it makes more sense to undo the tactical allocation and allocate fully to equities.
This is why expected asset return parity with differences in asset risk profiles provide great tactical opportunities.
Another opportunity exists because of high-yield's higher relative income return that's more frequently distributed versus equities.
Dollar Cost Averaging Optionality
High-yield’s significant income return creates another valuable option. In the context of this strategy, when you receive a distribution, you have three options:
Don't reinvest, keep in cash.
Reinvest into high-yield.
Reinvest into equities.
This can be used tactically depending on your long-term return expectations and funding goals. An example of a hypothetical portfolio manager's line of thinking below:
If high-yield and equities are expensive, don't reinvest and keep in cash (or invest in a money market fund) to redeploy later.
If high-yield provides better risk-adjusted returns, reinvest in high-yield.
If equities provide better risk-adjusted returns, invest in equities.
Pairing this with the option to roll down the entire high-yield position and you can get really creative using market timing-based rules, for example:
High-yield and equities are both expensive, invest distributions in a money market fund.
Equities are down less than 10%, reinvest distributions in high-yield.
Equities are down more than 10% but less than 20%, invest distributions in equities.
Equities are down more than 20%, sell entire high-yield allocation and invest in equities.
To be clear, this is just a simple example and not necessarily the market timing-based rules EID Capital uses. But the story remains the same, high-yield has more positive optionality compared to equities.
Downside Risks to Thesis
Now any honest thesis needs to analyze the scenarios that could cause the thesis to fail and as you'll see this thesis is far from a sure thing.
Standalone High-Yield Risks
If interest rates persistently rise alongside credit spreads, that could hurt short-term performance, although it will improve long-term return expectations (remember the price/return seesaw), as long as defaults don’t significantly pick up.
This occurred in 2022 but also during the 2013 Taper Tantrum, when Ben Bernanke suggested tapering bond purchases that began after the Global Financial Crisis. This suggestion caused some unwanted market volatility.
During this time both interest rates and spreads rose, which caused pain in both asset classes, although equities recovered faster than yield did. This was likely because equity risk premiums (as proxied by spreads) quickly recovered as did growth expectations. Meanwhile, high-yield had the continued headwind of risk-free rates rising until September.
Yes, rising risk-free rates impact equities, but it's implied that growth expectations rebounded quickly and much more so than the gradual rise in risk-free rates.
Another scenario is that spreads could go lower and remain low for the duration of the investment horizon. I severely doubt this will occur as illustrated by the historical 'US BB Option Adjusted Spread (OAS)' graph shown previously. Yes, current spreads are low historically speaking but a steady rise in spreads is a more likely scenario versus a gradual decline and pause over a longer time horizon.
The more likely scenario is that risk-free rates go lower and stay low. However, the going-in rate is a very important factor to high-yield's expected return and 4.30% is a higher than usual rate when looking at recent history. If you believe 10-year treasury yields are a good indicator of the direction for future short-term rates, then it's unlikely that interim rates will go back below 2.00% as has been the case, on-and-off, over the past decade. This is further backed by current Federal Reserve interest rate expectations.
The direction of interim rates and spreads matter because the high-yield fund's duration is 3.22 with an average effective maturity of 4.30 years. So there is some interest rate reinvestment risk (i.e., having to reinvest proceeds at lower future rates).
High-Yield Relative to Equities
When discussing the fundamental return drivers that would cause equities to outperform yield, earnings growth and assuming P/E reversion are the biggest risks.
Earnings growth can easily exceed my 6.32% expectation and with over 99% of companies reporting Q4 2023 results, EPS growth ending 2023 was 21.16%. In addition, bottom-up and top-down estimates suggest earnings growth will continue exceeding 6.32%. In the next five years, analysts are expecting earnings growth of 8.50-9.00%, in which earnings would have to drop off a cliff in the following five years for the 6.32% average to be realized.
Also, there’s no guarantee that the P/E multiple will converge to its long-term average. Time-after-time market prognosticators have looked silly assuming valuation reversion.
Equity markets can remain richly valued for a long, long, time and there's almost always the "next great thing" to keep markets excited about future growth opportunities. Ask any investment manager during the Dot-Com Bubble before it popped.
That being said, high expected growth rates and P/E ratios go hand in hand.
First principles, you're willing to pay more for an asset that's expected to grow faster, all else equal. If company earnings start to disappoint, not only will realized earnings be lower than previously expected, multiples will also contract as markets "re-rate" their future growth expectations. This causes a downside double whammy for equity returns. This is especially the case when there's a significant economic shock, like what occurred during the Global Financial Crisis, when earnings fell off a cliff and multiples collapsed.
Taking a more macro view. I mentioned previously that I don't put a ton of weight into absolute, non-adjusted historical returns when making future return assumptions. Instead, I look at historical equity risk premiums and apply it to the current 10-year rate. As mentioned, current 10-year rates are 4.30%. Adding that to the average 5.00% historical equity risk premium gives us a return of 9.30%. Remembering dividend yields are currently 1.26%, to get to a 9.30% return, EPS would have to grow at a 10.81% annual clip with P/Es normalizing to 20, grow at 8.04% with valuations holding steady, or a combination of something in the middle.
In reality, EPS growth and P/E reversion will likely be somewhere in between these scenarios described. But, I don't believe the combination will be enough to justify equities significantly outperforming high-yield. Besides, the 5% equity risk premium is just an average, and actual equity returns versus 10-year treasuries have varied widely. In fact, 10-year treasuries outperformed equities in the 2000 - 2010 decade.
But I digress, let's say equities are expected to outperform high-yield. What about the optionality benefits? Can the value of "rolling down your drawdown" make up for high-yield underperformance?
Well, there’s no guarantee a large equity drawdown will occur, although historically it's occurred every 6 to 7 years. Bluntly, I'm not worried about a large stock market drawdown occurring, it will. But, the timing of the drawdown matters. If it occurs near the end of the strategy horizon, when earnings and dividends have already contributed significantly to realized stock returns, equities might not fall enough for the optionality to have significant value.
For example, if equities outperform 30% and then fall 20% and high-yield only falls 10%, that return differential won't be enough to make up for the cumulative equity outperformance. Even if you "roll down your drawdown."
Client-Specific Considerations
As is always the case with any investment manager who manages numerous portfolios for a variety of clients, the appropriateness of implementing a strategy depends on many client specific factors. For some, it's almost a no-brainer, for others it's dead on arrival.
Portfolio Construction Considerations
Income Taxes
First, taxes. As mentioned repeatedly, high-yield's return primary comes from income (i.e., interest payments). Unfortunately, these payments are subject to ordinary income tax rates. Equity returns meanwhile, come primarily from capital appreciation and much of their dividends paid enjoy special long-term capital gains rate treatment (they're Qualified Dividends).
Equities are simply more tax efficient than high-yield.
So, the client's all-in ordinary income tax rate is a significant determining factor when thinking about this tactical allocation. The higher the client's tax rate, the less this strategy pencils. Also, investment managers swapping out of equities and into high-yield have to consider the after-tax capital gains haircut necessary to implement this strategy. The larger the unrealized gain (and the tax treatment of such) the less this strategy works.
This tactical positioning makes the most sense for tax advantaged entities (e.g., foundations, endowments) and accounts (e.g., IRAs, 401(k)s).
Portfolio Diversification Benefits (Especially vs. Tech)
Tactical positioning doesn't have to be all or nothing. In fact, high-yield acts as a good complement to equities, especially given the S&P 500's high concentration to the technology sector. After all, high-yield performed best relative to equities during the Dot Com Bubble, when equities drew down 45.49% relatively speaking, the highest disparity on record. Simply put, high-yield acts as a better diversifier when equities are richly valued and market turmoil is due mostly to excessive valuation multiples collapsing, as may be the case in today's A.I. hyped equity markets.
When looking at portfolio risk-adjusted return metrics, adding high-yield reduces overall portfolio market risk (beta) while maintaining expected portfolio returns. Also, yield's less than perfect correlation (0.66) against equities with lower volatility implies a superior risk-adjusted portfolio when diversifying into an all-equity portfolio.
Finally, high-yield's high-income component provides a nice increase in portfolio yield, which can increase the 'Dollar Cost Averaging Optionality' discussed previously.
Clients benefit more from a high-yield allocation if they have significant equity exposure and especially if they have significant tech exposure. The latter case is common with clients who work for tech companies and receive stock options, grants, and/or units as portion of their total compensation.
Behavioral Risks
Price Returns v. Total Returns
Most clients look at price returns and not total returns when comparing high-yield versus equities. High-yield price returns tend to decrease over time, possibly causing confusion and frustration when comparing returns v. equities.
This can be remedied by providing a total return view for clients or showing the total unrealized gain/loss by looking at tax lots. Both depend on the capability of your custodian.
Client Risk Tolerance/Behavior
Behavioral risk increases if the tactical allocation deviates significantly from their long-term policy portfolio (which is based on their portfolio objective). It can also increase if a client frequently checks their portfolio to see how their investments are performing. Finally, a lot depends on the personality and beliefs of the client, and how much they trust your judgement versus their own (whether justified or not) for whether implementing this strategy makes sense or not.
Risk-seeking, headstrong clients who check their portfolio frequently will be an uphill battle. A tactical underweight vs. equities will frustrate them if equities significantly outperform in the short-term, causing them to lose faith in your ability, raising complaints, drags on your time, and ultimately increasing the risk of being let go.
Meanwhile, for clients along the risk spectrum who trust your judgement and don't frequently check their portfolios, this is an excellent opportunity. Yes, education will (and should) be necessary but typically these clients are more receptive to tactical positioning if the argument is well thought out and clearly articulated.
To round out this paper, I'll provide some commentary given commonly stated portfolio objectives.
Tactical Positioning Given Stated Objective
Capital Preservation
Client: Short-term, low-risk tolerance client.
Target Return: Low
Implementation: Low opportunity. Mostly because clients who typically fit into a Capital Preservation strategy are very risk averse. Consider swapping equity exposure if it's in the client's portfolio as it will decrease overall portfolio riskiness while keeping expected returns intact. If the portfolio is made up of bonds and cash, consider a small-to-moderate high-yield exposure in the bond allocation to pick up yield. Cash-wise, I'd be very, very hesitant to touch cash allocations as it brings comfort to low-risk clients.
Income
Client: Short-to-medium term, low-to-medium-risk tolerance.
Target Return: Low-to-medium
Implementation: Good-to-great opportunity. High-yield is the highest income generating domestic public asset class, so it's a valuable option for income portfolios. It can get tricky if you designate the equity allocation to grow the real return of the portfolio over a long-time horizon. However, high-yield is currently generating an attractive real return to grow the portfolio and if a market drawdown occurs, rolling down your drawdown can get you back into equities at a better basis. Consider swapping or diversifying alongside equity exposure or long duration fixed income.
Capital Appreciation and Income
Client Profile: Medium-to-long term, medium-to-high risk tolerance.
Target Return: Medium-to-high
Implementation: Best opportunity. Capital Appreciation and Income clients are those typically reaching retirement age and need to live off portfolio proceeds for the duration of their life. If a client is reaching retirement age and there is a gap between from when they retire and to when they expect to take social security, high-yield can provide distributions to fund living expenses and also help alleviate sequence risk by providing a buffer against an equity market downturn. DCA market-based rules and "rolling down the drawdown" applies here too. Consider swapping or diversifying alongside equity exposure.
Capital Appreciation
Client Profile: Long-term, medium-to-high-risk tolerance.
Target Return: High
Implementation: Opportunity is wide (low-to-great) and depends heavily on specific client behavioral characteristics. Consider diversifying alongside equity exposure or replacing altogether. Allocating towards high-yield is "being risky by taking less risk", as equities outperform high-yield over very long-time horizons. This strategy will rely heavily on using DCA market-based rules and "rolling down the drawdown" to ultimately achieve high long-term equity exposure.
Afterward: Are High-Yield ETFs Experiencing Liquidity Issues?
The entirety of this thesis analyzed investing in each representative asset class through mutual funds. But with the rise in exchange traded funds (ETFs), does this strategy still work?
There has been a rising drumbeat arguing how the massive increase in passive fund flows can cause liquidity issues for ETFs which would especially be the case for high-yield bonds. After all, individual bond issues don’t trade near as much as the ETFs that hold them and during times of market distress, high-yield bid-ask spreads can blow out as uncertainty over the future prospects of the underlying company can freeze trading volume.
So, this argument warrants further discussion, especially as it pertains to the “rolling down your drawdown” strategy. If during times of crisis, liquidity dries up causing massive discounts to the underlying asset prices (as determined by NAV), then the argument of selling out of high-yield to reallocate to equities may be moot.
Starting off, we can see high-yield ETFs have had massive inflows, leading to greater assets under management.
However, greater assets under management have led to greater ETF volume. Which on face alleviates some illiquidity concerns.
But of course, greater volume doesn’t necessarily mean there aren't ETF price distortions.
Well, as we can see below, high-yield premiums/discounts to NAV haven’t increased significantly, in fact, it appears that they have come down significantly, especially for the ETFs with greater assets under management.
Historically speaking, pricing distortions have occurred during times of market distress, which is when it would make the most sense to sell out of high-yield and buy into equities.
When we look at the Global Financial Crisis (GFC) downturn, there were only two broad based high-yield ETFs, the:
iShares iBoxx $ High Yield Corp Bd ETF (HYG) and
SPDR® Blmbg High Yield Bd ETF (JNK) funds.
These ETFs were early in their fund life with low assets under management and little trading volume.
Despite this, rolling down your drawdown still would have paid off, as judged by the relative drawdowns between these two funds and the iShares Core S&P 500 ETF (IVV).
Looking today, the increase in assets under management and volume have decreased discounts/premiums to NAV over time despite drumbeats of the opposite occurring.
This point is further hammered home when looking at price behavior during the 2020 COVID Crisis. For context, the premium to NAV got as high as 12.76% and 9.96% and discount as low as -8.40% and -8.74% for HYG and JNK respectively during the GFC.
As we can see price distortions, as implied by premium/discount to NAV, have come down significantly as high-yield funds have gained in popularity.
Sure, the impact of the Global Financial Crisis had far more severe and lasting economic consequences. But, the velocity in which markets dropped in 2020 and recovered relative to 2008-2009 paired with the belief that increases in passive high-yield assets under management, should have led to far greater pricing distortions. This wasn’t the case, in fact, greater AUM led to greater liquidity, not less.
This leads me to believe that the market overall does a good job of pricing a basket of high-yield securities, despite the underlying illiquidity of each individual high-yield issue.
So as of today, high-yield ETF liquidity isn’t an issue. But you should consider the size of your position (or cumulative position across all portfolios) and the high-yield ETF (or ETFs) you choose to invest in. If the would-be position is sufficiently large, it’s good risk-management to stick with the larger high-yield ETFs or diversify across many ETFs to ensure sufficient liquidity during times of market distress.
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