Welcome to another weekend blog post from Systematic Income. In this quick post we highlight why it’s important for investors to keep a eye on how much yield they are actually earning on their income assets. This can avoid disappointment and help investors achieve their longer-term goals.
One chart that we find very helpful in income allocation is to just keep an eye on how much yield is on offer in corporate bonds of varying levels of quality. Specifically, we like to compare BBB and B-rated corporate bonds.
To give investors a quick sense of quality, BBB-rated bonds tend to suffer a cumulative default rate of about 1.8% over 5 years while B-rated bonds tend to suffer a cumulative default rate of about 18% over 5 years. That’s a big difference.
Now what’s very interesting is that investors who hold BBB-rated bonds (orange line) today are earning a higher yield than what investors earned in 2021 by holding B-rated bonds (blue line). In other words, today investors get paid more to hold much higher quality assets than in 2021. Another way to look at it is investors who chased “high” yield by holding B-rated bonds in 2021 have missed out on the chance to more than double the yield had they waited to buy those same bonds.
A common criticism we often hear is – no no, you are just “trading” or trying to “time the market” and all those things are “very bad”. “You should just buy and hold”. Well, call if what you will but earning 4% per year (that’s what was on offer in 2021 for B-rated bonds) on a portfolio of bonds that has an annual default rate of about 4.5% is not exactly all that appealing. We would much rather sidestep the market when valuations are unsustainably expensive. And if that’s called “timing the market” then fine by us. We’d rather end up with a greater amount of total wealth at the end than keep an allocation to assets whose valuation makes little sense.
TCW has put together a very nice summary of this dynamic in the following table. For example, investors who held CCC-rated bonds at a 6.8% in 2021 yield would be able to earn a higher yield today by holding BB-rated bonds. To give a sense of quality here – CCC-rated bonds have a 46% cumulative default rate over 5 years while BB-rated bonds have a 7.5% cumulative default rate over 5 years.
But how can investors know when to allocate to the market and when to sidestep it? Well, fixed-income market valuations are highly mean-reverting. A glance at the first chart above shows that yields move in a wide range. Yields that were on offer in 2021 were very clearly unusually low. This is not something we only know in retrospect today – it was obvious in 2021. It was so obvious we kept repeating it ad nauseam and probably lost a lot of readers because of it.
Investors who moved up in quality / resilience in 2021 not only preserved their wealth but can now move into much more attractively priced assets. This is the kind of countercyclical dynamic we like to follow on the service as well.
Right now, we like a number of higher-yielding assets. That includes BDC Blackstone Capital (BXSL) trading at a 9% yield and a 90% valuation on Q1 NAV. We also like the residential MBS Western Asset Mortgage Opportunity Fund (DMO) trading at a 10% yield and the Barings Global Short Duration High Yield Fund (BGH) trading at the 9.4% yield.
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