High yield corporate bonds, focused on double and single B investment grades, provide steady performance and moderate volatility, according to T. Rowe Price fixed income portfolio specialist Joran Laird.
Coupon return, the annual interest paid on a bond throughout its duration, drives returns, Laird told the Professional Planner Researcher Forum.
“The major driver of the return is the coupon – the collection, the reinvestment and the compounding,” Laird said.
“That’s what’s driving the returns… you’re not relying on prices rising, you’re not relying on yields falling or spreads, narrowing, what you’re wanting is for these companies to honour their obligations to pay you your coupon and give you your money back and you do that over and over and over again.”
But investors cannot take a passive view as the high yield index is made up of 3600 bonds with 1500 issuers and ETFs fail to match the index every year, Laird said.
“The main thing about high yield is to avoid defaults,” he said.
“Passive ETFs, they don’t care about that. They just buy what they can. But as an active manager, you’re doing that individual credit research, trying to find those companies that will honour their obligations that you’re getting rewarded for.”
Laird said the average credit quality of high-yield fixed income has never been higher because many “fallen angels” or former investment-grade companies, had downgraded to high yield-grade markets, while lower-rated high yield companies were accessing private credit markets for funding.
“That’s improved the average credit quality of high yield public markets,” he said.
Allocating high yield to a 60 per cent equity and 40 per cent treasury bond portfolio over the past 26 years, would not have changed the return of 6.5 per cent, but would have lowered volatility and was thus a more efficient portfolio, Laird said.
“[High yield] is not defensive, because there has that strong positive correlation with equities,” Laird said.
“But it’s not growth, because you make your money by the collection, the reinvestment and the compounding of coupon.”
Laird said this doesn’t fit into either the growth or defensive bucket but does serve as a good alternative and “enhancer” to both.
“It can serve to enhance returns in defensive portfolios and can lower volatility in growth portfolios,” Laird said.
“We believe this is an asset class that should be a permanent feature of the asset allocation. If you’re not invested, today represents a really good entry point.”
Laird said high yield added a lower volatility strategy to equity investments for advisers with clients in the drawdown phase of their investments.
“Each and every day that you own high yield, you are accruing coupon,” Laird said.
“No matter what happens to the price, each day, you’re earning coupon. That will act to reduce the worst drawdown from an equity perspective.”
While high yield bonds were a “much higher risk strategy” to a treasury-only portfolio, allocation to the asset class reduced drawdown.
“When I looked into it, [it] made a lot of sense,” Laird said. “How do treasuries lose money? They lose money when yields rise right.”
“High yield has got a significantly shorter duration than treasuries. So, you’re adding not only an asset class, that has got a lot of income accruing, but also has a lower duration [which will be] less sensitive to interest rate increases.”
