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If It Walks and Talks Like a Stock, It Must Be a… High Yield Debt In Disguise

Not all asset classes are as they seem...

Economist, Author, and Five Star Wealth Manager

Ivan Illán has excelled in both institutional asset management and financial advisory for more than 20 years. Ivan’s work has been featured in numerous articles including, The Washington Post and The Wall Street Journal. He’s a Forbes Contributor and Finance Council Member. Ivan is also ranked as a Financial Times Top Financial Adviser. He holds degrees in finance and philosophy from Boston College, the Certified Fund Specialist (CFS®) designation from the Institute of Business & Finance, and is a member of the CFA Institute, New York Society of Security Analysts, and CFA Society Los Angeles, where he’s a Founding Member of the Wealth Management League.
Ivan Illán has excelled in both institutional asset management and financial advisory for more than 20 years. Ivan’s work has been featured in numerous articles including, The Washington Post and The Wall Street Journal. He’s a Forbes Contributor and Finance Council Member. Ivan is also ranked as a Financial Times Top Financial Adviser. He holds degrees in finance and philosophy from Boston College, the Certified Fund Specialist (CFS®) designation from the Institute of Business & Finance, and is a member of the CFA Institute, New York Society of Security Analysts, and CFA Society Los Angeles, where he’s a Founding Member of the Wealth Management League.

vandermerwejolene9 via Pixabay

Asset classes can be defined by various characteristics. Features like market liquidity, cash flows, asset demand, and where it falls in the corporate capital structure, all play a role in determining asset classification. As the title of this article suggests, there are times when asset classes that are seemingly very different are in fact more similar than an investor understands. Making asset diversification assumptions is dangerous. It usually ends up overweighting highly correlated assets within a portfolio, adding insult to injury during market volatility peaks. You’ve got to run the calculations on asset correlation and covariance.

Over the past 10 years, junk bonds (aka, high yield debt) have had an eerily similar market value movement to US stocks, both in direction and magnitude (chart above). The covariance of high yield bonds to US stock market volatility (as measured by the VIX) is a whopping 240% higher than investment-grade bonds. What’s slightly more disturbing is that the covariance increased significantly during times of higher stock market volatility, meaning that the desired benefit of less portfolio volatility from asset diversification – flies completely out the window. On the whole, yields on junk bonds have improved very little over ten years ago, unlike stock values which have been an upward juggernaut. During the 2008-09 crisis yields spiked 350% from only 18 months earlier. Correspondingly, junk bond values collapsed 60-80% (bond prices move inversely to interest rates), while stocks were plummeting alongside. Market favor and sentiment can change very quickly, and effect various risk assets similarly.

As you move to higher credit quality, like BBB-rated debt, the covariance drops dramatically, though it still maintains a positive relationship. However, high yield bond ETFs (HYG, as an example) have seen nice double-digit returns over the past year, nearing the returns on stocks. With HYG’s average yield in the 5.27% range, it’s clear to see the appetite for low-quality debt has continued. But these types of ETFs are now selling at prices that are at a premium to their underlying NAV, which starts to look a bit rich. It’s more likely given the covariance history that a similar repricing, like the one we saw in 2008-09 (though much less dramatic) will happen when the next stock market correction of 10% or greater occurs.

Investors that buy junk paper would be well served to ask why? Are they looking for much higher income? At what cost? Most high yield funds have around 50% or more in B- and lower-rated debt. Defaults in junk bond categories are exponentially more common than BBB paper.

Sometimes, holding a simple stock index fund will deliver to an investor the same market value rollercoaster ride (as seen this past year), as a high yield bond fund, but will do so with less risk of permanent capital loss. Just remember, if it looks like a duck and walks like a duck, it not only is one, but it could end up being a much uglier duckling.