The price action across the income space has been large and seemingly unrelenting across most sectors. Such an extended drawdown as we have seen this year can make it difficult for investors to get their bearings and formulate a strategy. In this article, we discuss some of the pieces of our allocation strategy in this difficult time for the income market.
Having The Big Picture In Mind
Briefly, the current pricing in credit markets – based on the credit spread chart below – is at the level of either a Fed tantrum (e.g. 2013, end-2018) or a near-recession (e.g. 2015). A relatively mild recession, which increasingly looks to be a growing consensus, will likely require a further fall in prices – perhaps another 7-10% drop in the prices of high-yield corporate bonds, for example.
However, it’s worth nothing that coupon income will offset a big chunk of this further potential drop in bond prices, leaving defaults as the key driver of returns over the next couple of years. Much also depends on what happens to Treasury yields. A “typical” recession should see Treasury yields move lower, supporting bond prices. A stagflationary recession will drive prices even lower, however. Our base case is for Treasury yields to fall or remain stable in a recession. This has been evidenced by the recent drop in Treasury yields after the Fed acknowledged its willingness to drive the economy into a recession in order to push inflation lower.
It’s Easier To Be Less Wrong
Making allocation decisions have to take into account not just the outlook over the medium term, but also the current level of compensation for taking risk. An important bit of good news is that yields on a wide variety of income assets have risen substantially. For example, high-yield corporate bond yields have risen from a yield of 4% in 2021 to 8.5% now.
The obvious consequence here is that investors buying high-yield corporate bonds now are earning more than double what they did in 2021. The less obvious consequence is that markets need to deliver a much bigger yield spike in order for investors to break even.
For example, the HY corporate bond market has a duration of about 4.3. This means that an investor earning a yield of 8.5% needs yields to rise by around 2% in order to be left with a zero return after a year (i.e. 8.5% in yield less 2% x 4.3). An investor who bought HY corporate bonds in 2021 at a 4% yield could only afford a yield rise of 0.93% before starting to lose money on the position. We are, of course, ignoring the impact of defaults here, but that would be identical for both cases.
In short, a much higher starting yield makes it easier for investors to be less wrong. This is because the market has to work a lot harder to deliver a negative return outcome for investors. In addition, a rise in yields of similar magnitude as we just saw is also obviously a harder lift for markets the second time around. For example, a 2% rise from current yields would push the yield of high-yield corporate bonds within 1% of its peak over the past decade. That peak happened during a time when markets were pricing in a shutdown of a large part of the global economy – a far cry from what we are looking at over the next year or two.
Navigating the income market during a steep drawdown is never easy. However, having a number of heuristics and anchors in mind can make the process less emotional and less potentially fraught with regret. The heuristics discussed above are based on a good dose of humility as well as an awareness of historical patterns, and they make sense to us. Hopefully, they can be of use to other investors in the second half of this difficult year.
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