We are in times of great uncertainty about our economy and our country. We don’t know the duration or the depth of the economic impact of the coronavirus.
But we do know that the stock and bond markets have had their biggest drawdown since the 2008 financial crisis. We believe the sheer speed of the drawdown is in the process of creating a once-in-a-decade buying opportunity.
But even though we know how cheap the market is, and how much pessimism is priced in, we also know how difficult it is psychologically to start buying when the fear of further drawdowns is on everyone’s mind. We know that in 2008, stocks went down another ~20% after falling as much as this market has fallen. And our study on crisis investing suggests that the best time to buy has been 2–3 months after high-yield spreads hit 6%, which would imply during May to June.
So what is the best way to start buying? What should investors buy first to capitalize on this dislocation?
We think the credit markets, and parts of the high-yield market in particular, are an attractive place to deploy capital right now. Today, the high-yield bond market as a whole is yielding a remarkable 10.9%, while the highest-quality high-yield category (BB credit) is yielding 8.7%. For context, the average yield on the high-yield index from 12/31/2009-12/31/19 was 6.7% and BB was 5.2%. Riskier credit has repriced dramatically since January.
Figure 1: Yields on Investment-Grade and High-Yield Credit
Source: Bloomberg Barclays US Corporate Indices
As in equities, the sell-off in high-yield has been one of the fastest on record. High-yield spreads are now at levels not seen since 2009.
Figure 2: High-Yield Spread at 2009 Levels
Source: Bloomberg Barclays High Yield Index
Unlike equities, bonds are contractual obligations with set coupons and maturity dates. Unless they default, their returns are known. Even in default, bonds typically do not lose all their value.
While the range of uncertainties involved in equity valuation is vast, credit valuation is often a tractable problem even in times of great uncertainty. A few relatively simple inputs are all that is needed to price a bond – unlike the growth forecasts and discount rate assessments that make equity valuation notoriously tricky. Here, for example, is our estimate for credit returns over the next two years. The below assumes that 21% of high yield defaults over two years. The highest historical 2-year default rate according to Moody’s data since 1970 was 19% in 1990 and the next highest was 17% in both 2001 and 2009.
Figure 3: Our Expected Returns for Credit
Source: Verdad estimates. Assumes credit spread normalizes over a two-year period.
Are we certain of the above returns? No. But base rates from previous sell-offs suggest to us that credit could likely deliver positive returns quickly and be an easier initial investment than equities. And if default rates come in below the conservative assumptions above, the returns could be significantly higher.
This type of math might explain why high-yield had historically had limited downside after the initial sell-off and positive returns within 12 months even when equity markets remained highly volatile. To get a sense of how situations like this have played out in the past, we looked at four previous periods of market sell-offs to see how high-yield bonds performed from a similar point to where we are today.
Figure 4: High Yield Performance after Sell-Offs
Source: Bloomberg
Our research suggests that high-yield bonds tended to stabilize soon after the initial drawdown and were almost always positive within 12 months.
Entering 2020, the problem for pension funds and retirees was yield, which had led to the explosion of products to deliver yields well in excess of available treasury returns. We have been consistently negative on this idea. In May, we wrote a piece called “Fool's Yield,” arguing that the incremental yield available when investing in the lower-rated portion of the high-yield market had base rates of degradation and loss that negated that extra yield. In January, we wrote another piece called “A CCC Opportunity?” warning that CCC bonds were a horrendous trade.
Now, the situation is dramatically different. The fool’s yield, the point beyond which there is little incremental benefit to taking more risk, is now likely in the 7% range, after excluding energy and seriously challenged credit that has yet to be downgraded. This is coming very close to the return targets of many pension funds. As importantly, the incremental yield for taking more risk has now repriced in the right direction.
We think investors should strongly consider allocating to the high-yield bond market right now. 7% yields on BB bonds don’t come along every day, and volatility in credit is much lower than in equities.
Disclaimers:
This does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. This information generated by the charts, tables, and graphs presented herein is for general informational and general comparative purposes only.
This document may contain forward-looking statements that are based on our current beliefs and assumptions and on information currently available that we believe to be reasonable, however, such statements necessarily involve risks, uncertainties and assumptions, and investors may not put undue reliance on any of these statements.
References to indices or benchmarks herein are for informational and general comparative purposes only. Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index.
The information in this presentation is not intended to provide, and should not be relied upon for, accounting, legal, or tax advice or investment recommendations. Each recipient should consult its own tax, legal, accounting, financial, or other advisors about the issues discussed herein.
