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Bond Allocation Dilemma
05/22/2020 9:10 am EST
With long-term Treasury providing very little yield, are high yield bonds a better alternative? Joon Choi explores this question.
The uncertainty of the global economic recovery from the Covid-19 virus resulted in a plunge in interest rates around the world. Specifically, the 10-year Treasury yield (TNX) fell from 1.92% at the start of the year to 0.5% in early March and closed on May 19 at 0.71%. This resulted in lower yields on investment-grade bonds and investors are now left in a conundrum on the equity/bonds mix for their portfolios.
Here, I will discuss why high yield bonds may provide a much better opportunity in our current investment climate.
Investment-grade vs. high yield bonds
I chose the Vanguard Total Bond Market Index Fund (VBMFX) and Vanguard High Yield Corporate Fund (VWEHX) because of their extended historical data. They are considered investable benchmark vehicles in their respective categories. Although downward pressure on yields led to a low SEC yield of 1.4% for VBMFX, the yields on VWEHX rose to 5.85% as investors pulled money out of risky bonds. That is more than four times that of investment-grade bonds. Of course, there is no such thing as a free lunch in life and high-yield bonds have significantly elevated risk compared to VBMFX.
So, investors are faced with the choice of whether to invest in a low-yielding investment-grade bond (which can lose a year’s worth of yield of 1.4% if the 10-year Treasury yields spike up 0.3%) or reach for the yields by increasing exposure to high yield bonds. Is the extra yield worth the risk?
10-year Treasury yield analysis
Long-term interest rates have been on a downtrend since the early 1980s. TNX has been down trending at a steady pace since 1993 as the best-fit line (trendline) seems to fit the yield decline well (see chart below). Notice how far TNX deviated the best-fit line in late 2018 prior to the near 20% correction in the S&P 500 Index. Looking back, it did not appear that yields could maintain those extended levels from the trendline. The current level is below the long-term average, but it does not look too stretched when compared to previous instances.
I uncovered something interesting when I charted the 12-26 month Moving Average Convergence/Divergence (MACD) indicator of TNX (the difference between 12-month and 26-month moving average). The MACD seemed to be oscillating within a certain range reaching its major support level this month (see chart below). There were four other instances that the indicator bounced off the MACD support level.
I recorded the dates from when the MACD reached the support level to the peak of the MACD; this analysis can be a bit biased because you don’t know when the MACD had peaked out until after the fact (such as Point B in Chart 2). I then calculated the performances of investment-grade (VBMFX) and high yield (VWEHX) bond funds along with three other high yield funds that we invested in (see table below). The average gain for the four start dates ranged from 5.1% for VBMFX to 24.1% for Fund 2.
When the returns were annualized, the gains ranged from 2.7% to 11.8%, resulting in more than 9% difference between VBMFX and Fund 2.
From the start of the first example on Jan. 29, 1999 to the end of the last example on June 30, 2014– a duration of 15 years and 5 months, the annualized return for VBMFX was 5.1%; almost double the return (2.7%) during the four examples. Out of these 185 months, the MACD of Treasury yields indicated rising trends for 89 months, or almost half the time.
The annualized returns for the high yield funds over the entire 1999-2014 period were significantly less than the rate of gain they achieved when the monthly MACD rose from the major support level. In fact, Fund 2 achieved 5.9% better return (11.8% vs. 5.9%) when TNX rose during the four time periods above. What this implies is that high yield bond funds rose briskly during the periods when long term interest rates were rising and barely budged (including interest) when long-term interest rates were trending down.
The traditional 60/60 allocation of 60% equity and 40% bond is at risk as investment-grade bonds offer only a 1.4% SEC yield with potentially significant downside risk if interest rates head higher from their current historically low levels. In fact, a sharp 0.3% spike in the 10-year Treasury note yield will wipe out a year’s worth of interest.
I believe high yield bonds offer a much better alternative as their yields are significantly higher and they perform better during periods when yields are rising. During the four periods cited above TNX’s monthly MACD rose from current levels, high yield bonds performed much better as they returned 8.1% more than VBMFX; 10.8% vs. 2.7% respectively. I believe investment-grade bonds do not offer a favorable risk/reward potential and reallocation to high yield bonds may be in order.
However, there is no guarantee that interest rates will enter a multi-year up cycle as they did in the examples provided above. Therefore, it would be prudent to use a high yield bond trading models like ours to further improve the return/risk relationship. Our high yield investments have returned approximately 3% with a 2.4% maximum drawdown in 2020 as of this writing; whereas JNK (a widely followed high yield ETF) is down 8% and experienced a 22.8% drawdown this year.
Joon Choi is Senior. Portfolio Manager/Research Analyst at Signalert Asset Management. Sign up here for a free three-month subscription to Dr. Marvin Appel’s Systems and Forecasts newsletter, published every other week with hotline access to the most current commentary. No further obligation.
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