Published February 24, 2021
Bond prices tend to move less than stocks day-to-day because investors are more certain about their future cash flows. So if bonds are math...I'd say stocks are stories.
Bond prices tend to move less than stocks day-to-day because investors are more certain about their future cash flows. So if bonds are math...I'd say stocks are stories.
Generating steady income while successfully managing riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. is what every bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. investor aims for—and we think a tactical investing approach can help get you there. Director of Research Jeff DeMaso and Quantitative Investments Manager Josh Jurbala are back for the second part of our multi-episode look at tactical investments, this time diving deep into the investing philosophy behind our approach to tactical high income.
In this insightful conversation, Jeff and Josh discuss:
Tactical investing is a disciplined, rules-based approach that can help eliminate the emotional biases all investors are prone to. It’s not for everyone, but is tactical for you? Click above to listen now!
Hello, and welcome to another The Adviser You Can Talk To Podcast. I’m Jeff DeMaso, director of research at Adviser Investments. And today I’m joined by my colleague, Josh Jurbala, our quantitative investments manager running our tactical strategies. Josh, welcome back to the pod.
Hey, Jeff. Great to be back.
And I am glad you are here, as this is the second installment of a series of conversations we’re having around tactical investing. We spoke late last year and laid out the foundation for these conversations. We discussed our philosophy, how we approach and think about tactical investing. So if you, the listener, want to hit pause on this episode and go listen to the first one, you’re welcome to. But I think this conversation will stand on its own two feet.
Because today we’re going to talk about one of our tactical strategies, in particular, Tactical High Income. We’ll get into the details, so let me just lay out the elevator pitch on the strategy upfront. Everyone would like to earn a higher income or more yield from their investments, and that’s especially true in today’s low-yield environment. But we know that with more income, comes more risk. So this is our approach aimed at capturing the higher level of income on offer in the junk bond market, while managing the risks that come with it.
Now, again, that’s just the short story. Josh, let’s try and tell it in full a little more completely. And I think the place that you and I need to start is at the beginning. So question number one, what are high-yield bonds?
Sure. And let’s even start with a quick overview of bonds in general. At a high level, bonds are debt securities issued by companies and governments to raise capital from lenders, so the bond investors or bond holders. Think of bonds as an IOU or a way for companies to borrow money. Typically, bond investors are paid interest by the issuer at a stated rate or a coupon on a regular basis. And then they’re paid back their original investment at the stated maturity dates, say five, 10 years.
We typically group bonds by credit quality or the financial health of the issuer. Investment-grade bonds are viewed as the highest quality, the most likely to make interest payments and payback principle. And these are U.S. government bonds or Treasurys, which are considered the highest-quality bonds, least likely to default. And then there are also investment-grade corporate bonds. So companies like Microsoft and Apple, which have great fundamentals and could be relied on to make payments.
And then on the other side of the coin, we have high-yield bonds, which are referred to as junk bonds due to their lower credit quality. These are considered less likely to make payments and they tend to carry more debt and have a higher probability of defaulting on obligations. And these junk bonds pay these higher coupons or a higher yield than the high-quality bonds to compensate investors for that additional risk that they’re taking on.
So for our purposes, we typically focus on U.S. high-yield corporate bonds, but it’s important to understand investment grades and Treasurys to get a full picture. Investing is all about weighing risk versus return. So with high-yield bonds, we typically measure relative value versus those safer options, and to see if that high-yield is worth the extra risk.
Yeah, that makes sense to me. Not all borrowers are equal or as likely to pay back their debt, so the market doesn’t treat them all the same. I think one other important aspect of bonds is their predictable returns. Bonds are often called fixed income, because when you buy a bond, you know exactly what your return will be. Assuming, A, that you hold it to the end of the bond until maturity, and B, that all goes well and the company doesn’t default. So in this way, we kind of think of bonds as math.
Definitely. And that’s an important point because it helps explain why most bonds, even high-yield, are considered less risky compared with stocks. Bond prices tend to move less than stocks day-to-day because investors are more certain about their future cash flows. So if bonds are math, like you said, I’d say stocks are stories. Your expected return when you hold a stock is based on many factors, future earnings growth, cash flows, management decisions, for example. All this is more uncertain, and so that’s one reason stock prices swing more day-to-day as investors react to news and events that could affect the future outlook of those factors and of the company.
And meanwhile, to your point, bond investors mostly care just about whether the bonds will default because if they don’t, the math works and they’ve received their expected return. And even if the company defaults, bond holders are typically paid back before equity holders, so that makes them also safer. Even for high-yield, defaults are pretty rare in good economic times. Default rates only average 2% or 3% most years.
So most of the time a well-diversified high-yield portfolio is relatively safe. And that explains why high-yield prices stay steady in good economic times, but can sell off suddenly when events derail the economy and even bond investors fear the worst.
Yeah, I think that’s an important point to stress, Josh, that idea … I mean, high-yield bonds sound scary, junk bonds sound scary.
But besides for that occasional sell-off, most of the time you can expect that consistent return from high-yield. You just want to be in the asset class, clipping that coupon], earning that high income.
So I’m sure we’re going to come back to that again, I think that’s a really important thought that we’ll need to connect, but let’s start with returns. We’ll come back to risk as well, but let’s start with the return side of the equation, and who should consider investing in high-yield and why?
Well, we think high-yield’s worth investing in, in most environments for most people, for three reasons. First, for investors who want income, like retirees, high-yield bonds still provide higher relative income to investment grade. Second, if you’re reinvesting that income, a high-yield bond portfolio can offer greater growth potential compared to traditional bonds. Almost 9% of annualized total return over the past 30 years, versus 6% for Treasurys and 7% for corporate investment-grade. And meanwhile, stocks have returned 11% annualized.
But the important point to make here is that if you’re just holding over long periods, that growth isn’t typically … That’s not for a price appreciation, like stocks, it’s from reinvested income compounding over time. So most of the time you want to stay invested in high-yield. Then the third benefit of investing in high-yield is that it’s performed well in rising rate environments, which is an important point to stress recently, as people have been worried about rising rates.
And this is mostly because when rates rise, the economy is recovering or in the middle of a growth cycle. And when the economy is growing, investors are confident that lower quality, high-yield bond issuers are more likely to generate profits and pay interest on those bonds. Given those benefits, we think the current market environment’s still supportive for high-yield investment.
Okay, Josh, I’m going to put on my skeptic’s hat here. Let me push back a bit. You mentioned 9% historical return from high-yield, and that’s great. That’s in the numbers, it’s what it’s done, served a lot of investors well. But I think we’re going to be hard-pressed to see that from here.
I’ve been joking for some time now that we can’t keep calling junk bonds high-yield. And I looked this morning, the index only yields about 4% today, and that’s only, what’s that, 2.5% more than Treasury bonds or so. So let me push back on that last point there. Why is today a good environment for high-yield?
Those are good points, and that’s true. Spreads have tightened a good amount, but we still think there’s opportunity there. And we see two main tailwinds for junk bonds; one, the economic recovery and two, low interest rates. And the simple reasons behind that are an improving economy and low borrowing costs mean better prospects for struggling companies and fewer defaults, as I mentioned earlier.
And to your point on absolute yields. Yeah, sure, 4% seems low, but bond yields are low across the board. So, cash money markets are paying next to nothing. And the 10-year Treasury, even after the run-up in recent weeks, is still just over 1%. Investment grade corporates are just under 2%, less than a 1% spread over Treasurys. And so this means income seeking investors have fewer options, so that extra 3% high-yield offers over Treasurys is nothing to sneeze at, I would argue.
But the key point to add here is actually, I don’t really care. The point of the tactical systematic approach is that I don’t need to make a call on the high-yield market. The tactical strategy dictates whether I should be in or out, so that’s what I follow.
Okay, that’s fair enough and that’s a good point. So let’s maybe talk before we get to the tactical strategy, talk about the risks. What type of drawdowns have we historically seen in the high-yield bond market?
High-yield can experience equity-like declines, usually at the same time that stocks fall. And as I said, these sell-offs are typically triggered by major economic shocks, when investors panic and sell everything, especially equities and debt in the riskiest companies. And we’ve seen a number of examples of high-yield falling nearly as much as stocks over the past 30 years. During the financial crisis of oh seven, oh eight, high-yield bonds fell 35%, as equities fell 55%. In 2015, high-yield fell 13%, same as stocks due to that energy crisis that year. And last year, just last year, we saw high-yield sell off 21% while the S&P sold off 34% in just 23 days.
For an investor holding high-yield bonds as part of the bond portion of their portfolio, they might be caught off-guard during those times when diversification doesn’t work as expected, and suddenly a greater portion of their portfolio is acting like equity. And this is just particularly concerning for those income-seeking, more conservative investors who need to protect their capital and withdraw income at the same time their investments are selling off.
Yeah, I think that’s a key point. I mean, you had me at the beginning when we were talking about higher income and clipping those coupons. But those are some material declines, 20%–30% for, as you said, income-seeking and conservative investors. So what’s our solution to this part of the market?
Well, that brings us to tactical. We believe a tactical approach is best suited to help reduce risk while enhancing the potential return of high-yield bonds. As we discussed in our last episode on tactical, these strategies are systematic and rules-based, just ensuring you have a plan in place to help with both the offense and defense invested in high-yield bonds.
And defense determines when to de-risk and protect your portfolio from extreme loss. While the offensive side of the strategy ensures you have a rules-based signal to reinvest and take advantage, or take advantage of the potential price appreciation when prices are low.
Okay, yeah. Josh, I think you’re going to probably try and connect some of these dots for me here. I feel like we’ve laid out some breadcrumbs.
What makes tactical a good fit for the high-yield asset class?
It has to do with what we’ve discussed on how high-yield bonds behave and the consistency of that behavior. Remember, you said, bonds are math. High-yield bonds typically deliver steady income and prices are relatively steady in most environments. You want to remain invested and keep clipping that coupon. But prices can selloff suddenly and that can be tough to sit through, detrimental if you panic and sell late. But just like stocks, bond investors overreact, prices dislocate and can snap back pretty quickly. If you can avoid most of that drawdown, you can take advantage by reinvesting while prices are still low.
And while this dynamic’s not certain, it is relatively reliable. It’s more reliable than the movement of stock prices, at least, which makes high-yield well-suited for that rules-based systematic approach we’ve talked about. And the key point here is knowing not just how prices tend to move, but developing an intuition for why they move, because then we can have confidence our strategy will continue to perform reliably going forward. And that’s the point of our Tactical High Incomestrategy, which is designed specifically to target high-yield for that reason.
Yeah. I think that’s super important, understanding the why. I mean, we can all run spreadsheets and tests and find something that used to work, but it’s also important of having that underpinning that gives us confidence going forward.
So, yeah, let’s pop the hood a little bit more and talk specifically about how our Tactical High Incomes trategy works.
Sure. There’s three main characteristics that differentiate our strategy from other yield-focused tactical strategies. First, Tactical High Income specifically targets the U.S. high-yield bond market. And the strategy is built to address the unique aspects of high-yield we’ve discussed. Second, the strategy uses cash as a buffer asset, and will defensively trade half the portfolio or all the portfolio to a cash money market when high-yield sells off. We don’t use Treasurys for a defensive buffer just to avoid complicating trade signals.
And strategy also uses ETFs, which is a third differentiating factor, providing top-level liquidity and enhances our ability to actively trade in shorter timeframes. This is, instead of mutual funds, with trade restrictions or individual bonds, which are illiquid and difficult to trade. The point I’ve made in our last episode on tactical, was we focus on simplicity over complexity and making tactical practical. Those three features aim to do that.
Yeah, that’s great. I think we could probably even go a little bit more into the nitty-gritty. I mean, you’ve alluded to trading half the portfolio with quantitative systems. So I guess my question is, is this rules-based? Give me some of the nitty-gritty on it here.
Sure. The strategy itself is relatively straightforward. We trade two sleeves of the portfolio between high-yield ETFs and cash. The two sleeves are equal weight, so 50% each and each holds a basket of high-yield ETFs. One half of the portfolio follows a fast signal, which is more reactive. On defense, it’s quicker to go to cash and it signals earlier when prices drop. On offense, it’s more reactive and buys in sooner when bond prices rally.
The other half of the portfolio follows, you guessed it, the slow signal, which is defensively slower to go to cash and waits for more confirmation of a downturn before getting defensive. On offense, it waits for a little bit more of a long-term positive trend to reinvest. The main premise behind this strategy is to deliver a systematic and unemotional approach to invest in at high-yield. It maximizes exposure when prices are steady and you want to keep clipping that coupon, as we’ve mentioned, but it’s ready to reactively trade the cash to protect your portfolio as much as it can.
Okay. We can’t go into specifics on performance, but maybe you can describe how the strategy behaved in 2020. And I guess if we’re going to talk last year, we have to start with, how did it handle March’s sell-off?
Of course. Yeah, 2020 is a good example of the pain and the gain potential in high-yield, and how the strategy can work on both defense and offense. The strategy got defensive and reacted quickly when high-yield and stocks began to sell off in late February of last year. Strategy sold the first half to cash on the last day of February, and then went to all cash on the first trade day of March. So it was fully in cash as high-yield fell another 15% and it missed most of that drawdown.
On offensive, the strategy reinvested relatively quickly on the rebound, first buy-in on the last day of March and then in mid-April. So it handled that March drawdown and the recovery pretty well.
Yeah, it sounds like it did. How did the rest of the year play out?
Well, there were some missteps. The strategy went to cash when it didn’t need to a couple of times, and it missed some of the upside. And that’s the whipsaw that we spoke about last episode that sometimes happens with tactical. And that happened in June when markets were noisier, as the virus cases rose and threatened further lockdowns and high-yield sold off a bit, but then came back and continued to rally.
But overall, the strategy remained mostly invested for the year. It averaged 85% exposure to high-yield, which aligns with our goal of extending your exposure to the high-yield bond asset class.
That’s great. I think that’s a really good example of both the pros and cons of tactical. As we’ve said, and I’m sure we’ll say again, it doesn’t work all the time. Not every trade is a winning trade. So you need to be willing to sit through some under-performance.
But for certain investors, tactical can be a useful tool to manage risk and take advantage of the opportunity and some of these riskier assets, like high-yield bonds.
Yeah, exactly. And we often say that, “Your concerns are as important as your returns,” which simply means that you can’t ignore the risk side of the equation. Our Tactical High Income strategy aims to deliver income in a low-yield environment, while keeping risk in mind.
Josh, I think that says it well in is probably a perfect note to end on. Thank you very much for joining me in this conversation. Looking forward to the ones we have down the road.
Yeah. Thanks for having me, Jeff. This has been great.
Excellent. This has been Jeff DeMaso and Josh Jurbala from Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast. If you enjoyed this conversation, please subscribe and review our show. You can check us out at adviserinvestments.com/podcasts. Your feedback really is always welcome. If you have any questions or topics you’d like us to explore, please email us at info@Adviserinvestments.com. Thank you very much for listening.
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