How overreaching for yield may lead to disaster

Summer 2020

Key takeaways

  • We think high-quality should be the core focus of a sound fixed income strategy.

  • When times are good, investors may be tempted to ignore high-quality bonds and over allocate to high-yield securities.

  • However, these higher yields mean higher risks that can become quite problematic during major market crises.

  • Market dislocations like COVID-19 offer an important reminder of why fixed income is critical: for ballast when a portfolio needs it the most.

Events in recent months have upended everyone’s lives, and we hope that you’re staying safe and well during these challenging times. Although the COVID-19 crisis is unprecedented, experienced investors have endured several major market dislocations in recent years, providing some preparation. Thankfully, the Federal Reserve quickly activated a wide range of programs engineered to ensure that credit markets remain liquid. Yet these programs and fiscal stimulus can only do so much, which is why the guidance that you share with clients can make a profound difference on how well their portfolios weather market storms.

If the key to investing in real estate is location, location, location, then when it comes to successful long-term investing, we believe the key is diversification, diversification, diversification. Unfortunately, some of your clients may have thought themselves sufficiently diversified heading into the pandemic, only to find that they had ventured too far down the rabbit hole while chasing higher yields. In this scenario, the bonds they had expected to provide ballast likely sank alongside their stocks in March as equities tumbled.

In this edition of our recurring fixed income insights, we examine four sequential phases that investors may have experienced during the COVID-19 pandemic if they had opted out of a high-quality approach, which we believe should be at the heart of a sound fixed income strategy.

Phase 1–Overreaching for Yield

When market conditions are good, investors might be tempted to shrug off the importance of a high-quality fixed income core allocation in favor of reaching for extra yield. During extended periods of market optimism and calm, it can seem appealing to chase higher yields by adding low credit-quality bonds.

In this phase, spreads are tight, liquidity is readily available, and flows into bond funds are plentiful. Some investors may find it enticing to downplay the fundamental differences between high-quality bonds (like U.S. Treasuries and investment-grade corporates) and lower-credit-quality fixed income, like high yield.

The first chart below shows the performance trend leading up to the 2008 financial crisis. Amid historically low
interest rates, some investors began to overreach for yield, overloading their portfolios with lower-credit-quality bonds, while believing their safety anchor remained intact. The second chart of the COVID-19 pandemic shows a similar pattern. During the most recent iteration of this phase—late last year—the Bloomberg Barclays U.S. Corporate High Yield Bond Index was outperforming U.S. Treasuries, as was the Bloomberg Barclays U.S. Aggregate Index. This strategy can pay off, until it doesn’t ... like when an inevitable major crisis strikes.

Exhibit 1: A closer look

Phase 2–The yield temptation increases

In the second phase, signs of market distress begin to appear. Riskier assets sell off a little—ironically, leading to even higher yields. Liquidity somewhat diminishes as spreads widen, but high-yield fixed income flows still rise
as investors reach for even more yield due to the slightly elevated rates. Markets start to increasingly price in the
risk of defaults, and yields rise further, thereby making high yield “appear” even more attractive to some investors.

When this happens, investors who have already overreached for yield can be enticed to stretch even further still. And they find themselves venturing into even lower credit quality to do so. These investors often replace still more of their high-quality fixed income core allocation with lower-quality bonds offering higher yields, sacrificing potential portfolio diversification ballast in the process.

This phase started in early February 2020, when concerns regarding COVID-19 began to solidify. The pandemic crisis chart above shows that high-yield performance began to peak and leveled off at this point, while Treasury returns continued to rise steadily. A very similar pattern played out during the 2008 financial crisis.

Phase 3–The yield starts to act like equities

The third phase tends to be characterized by a stressed market environment. Liquidity rapidly diminishes, widening yield spreads, and low-quality bond funds experience heavy outflows. Yields rise further still as prices drop significantly. In this environment, high-yield bonds increasingly correlate with equities. Investors who strayed from a high-quality core approach may start to worry about their portfolios, as their bonds and stocks both begin to sell off in earnest. In this phase, the appealing illusion of their fixed income diversification fades to reveal the unattractive realities of this yield-grab approach.

The third phase began in late February 2020. As COVID-19 volatility worsened, high-yield performance began to decline sharply, significantly lagging the modest downturn of the broader U.S. bond market. However, the performance of Treasuries was generally unaffected, as seen in the COVID-19 chart on the prior page. The underperformance of high yield became increasingly correlated with equities during the market selloff (illustrated in the chart below), virtually eliminating the potential diversification benefits of fixed income. As we moved into March, the correlation between the two asset classes regularly approached 0.9. This is the worst-case scenario, high-yield fixed income almost perfectly tracked the underperformance of the equity market.

Exhibit 2: High-yield

Phase 4–Throwing in the towel

For lower-credit-quality bond approaches geared toward maximizing yield, the final phase is when the inherent dangers truly emerge. Prices on risky assets plunge as volatility rocks financial markets. Liquidity is incredibly problematic, and yield spreads widen to extremes amid fire sales. The correlation between high-yield bonds and stocks can reach historically high levels in such scenarios.

For investors who overreached for yield, both their fixed income and equity investments are now material drags on their entire portfolio. Bond allocations are no longer providing ballast as equity markets sell off because the overexposure to low-credit-quality bonds has virtually eliminated the potential diversification benefits. Worried about the increased deterioration of their net worth, these investors may begin selling their high-yield bonds at the worst time possible in a market crisis cycle.

This phase began in March, with both the high-yield bond and S&P 500® indexes declining around 12%, as shown in the chart below. An investor in high-yield bonds from July 2019 through March 2020 may have experienced losses two to three times greater than the potential relative gains they might have otherwise realized if the markets had remained essentially static and no crisis had occurred.

Final takeaways for your clients

The four behavioral phases we discussed in this edition of our fixed income insights have repeated over the years (the Russian debt crisis in 1998, the financial crisis in 2008, and now the COVID-19 crisis) and will almost certainly happen again. Tight spreads tempt investors to overreach for yield, risking underperformance and lost principal in a crisis. And although the Fed stepped in to help with the pandemic, constructing a portfolio that relies on a Fed backstop for diversification protection is quite risky. Rather than count on governments or central banks to save the day, a wiser plan is to ensure that your clients’ credit risk exposures are aligned with their long-term financial goals.

A great way for your clients to achieve the diversification benefits of fixed income is to start with an allocation to high quality fixed income, like the Bloomberg Barclays U.S. Aggregate and U.S. Treasuries. If your clients are using bonds as a safety anchor for their portfolios, help them understand the importance of a high-quality focus, even if it means foregoing some yield in the process.

Moreover, although all corporate bonds have some risk, fixed income diversification becomes more of an illusion the further down in credit quality one stretches. Help your clients realize that if their only focus is yield, they may wind up throwing in the towel during the next major market crisis.

About the author

Brett Wander

Brett Wander, CFA

Managing Director, Chief Investment Officer, Fixed Income Strategies