How Monetary Policy Drove Up Risks in High-Yield Bonds
New research shows that aggressively easy monetary policy has driven asset flows to high-yield corporate bonds. Those bonds now offer poor risk-adjusted returns and have made certain interval funds more attractive.
In response to the pandemic, the Federal Reserve and U.S. Treasury aggressively supported the corporate debt markets in 2020, both through easy monetary policy and direct participation. As the economy recovered, the Fed has maintained an easy monetary policy in pursuit of more robust employment, gross domestic product growth and inflation targets.
Faced with minuscule returns at the low end of the risk spectrum, many investors, especially those who follow a cash-flow approach (spending only from dividends, interest and distributions) versus a total-return approach, concluded that there was no alternative but to move higher on the risk curve than they have historically, causing the prices of riskier assets to trade higher relative to low-risk assets.
Consider the following example. According to Morningstar, As of November 3, 2021, Vanguard’s High-Yield Corporate Fund (VWEHX) had an effective duration of 3.6 years and a yield to maturity of 3.7% ; it had about 55% of its holdings in BB-rated bonds, about 28% in B-rated bonds, 6% in bonds rated below B and 2% in bonds that were unrated (the remainder were rated investment grade, with about 4% in BBB-rated bonds and about 5% in AAA-rated bonds, presumably for liquidity purposes). At the same time, the Cliffwater Corporate Lending Fund (CCLFX), which invests in directly originated middle-market loans, is yielding about 7.8% (4.1 percentage points higher than the yield on VWEHX) and has no duration risk, as loans are all floating rate. In addition, the vast majority of the loans are senior secured to firms backed by private equity investors, and the average loan-to-value ratio (LTV) is below 50%. Cliffwater estimates that if their loans were rated, they would be rated B/B- (similar to the ratings on VWEHX). Clearly, a large percentage (perhaps half) of the yield difference is a liquidity premium because CCLFX, as an interval fund, only offers limited quarterly liquidity.
In terms of credit risks, over the period 2007-2019, the Cliffwater Direct Loan Index (CDLI) experienced credit losses of 1.3%, less than the 1.5% losses experienced by the Bloomberg U.S. Corporate High Yield Total Return Index. And CCLFX’s loans are less risky than the loans in the CDLI, as they have lower LTVs and a higher percentage are backed by private equity investors. Thus, while CCLFX has about 4% higher yield than VWEHX, its portfolio is significantly less risky from an inflation and credit perspective. For investors able to allocate some portion of their portfolio to illiquid assets, CCLFX provides significantly higher returns, reduces inflation risk and also reduces credit risk relative to VWEHX. So why is VWEHX yielding only 3.7%?
Has the Federal Reserve’s zero interest rate policy led investors to have such a preference for yield that they are mispricing risks for public securities?
Edward Altman and Mike Harmon sought to answer that question in their paper, “Risky Corporate Bonds in 2021: A Bubble, or Rational Underwriting in a Low-Rate Environment?,” which was published in the November 2021 issue of The Journal of Portfolio Management. They analyzed the valuations and expected returns of the CCC-rated portion of the corporate high-yield debt market to determine if high valuations simply reflected the low risk-free rate or whether valuations were excessive: Have record loose financial and monetary policies encouraged and enabled excessive taking of risk?
Altman and Harmon began by noting that the Federal Reserve tracks an indicator called the “excess bond premium,” which measures the residual of a regression of corporate bond spreads against controls for firms’ expected defaults. The historical mean of zero represents a level at which the market appears to be pricing in historical default rates relative to historical periods. Negative readings indicate that investors’ risk appetite is above its historical mean. As shown in the chart below from the Board of Governors of the Federal Reserve System Financial Stability Report, May 2021, recent readings for this metric are close to all-time lows, indicating an excessive risk appetite among investors.
In the report, Fed Governor Lael Brainard stated: “Corporate bond markets are also seeing elevated risk appetite, and the spreads of lower quality speculative-grade bonds relative to Treasury yields are among the tightest we have seen historically.”
Altman and Harmon then noted: “It is remarkable that there have been any periods of extremely high new issuance of CCC-rated bonds in any year given that almost 50% of newly issued CCC bonds have historically defaulted within five years of issuance. In addition, the median Z-score (a numerical measurement that describes a value's relationship to the mean of a group of values, measured in terms of standard deviations from the mean) of CCC-listed firms every year since the early 1990s is below 1.0 (including 0.73 and 0.92 in 2019 and 2020, respectively), indicating a relatively high probability of default within two to three years. Thus, to help draw broader conclusions regarding the presence of bubble-like behavior in high-yield bonds generally, we will focus on the CCC portion of the market specifically.” The CCC portion of the high-yield market has historically had very high default rates, with approximately 47% of those bonds defaulting over a five-year period and 61% defaulting over a 10-year period in a study covering 48 years.
The CCC market today
Altman and Harmon noted that the option-adjusted spread of the Bloomberg Barclays CCC Index, which is the spread over corresponding U.S. Treasury securities adjusted for the imbedded value associated with issuer call options, was at a 14-year low of 4.5% as of July 2021 (about half the level they were at year-end 2019). Investors were requiring less of a risk premium to own these securities relative to any period in the last 14 years, and the last time the CCC spread was this low was in 2007, just prior to the global financial crisis. Importantly, they noted that the CCC spread reaching 14-year lows is not, by itself, evidence of a bubble. However, spread compression is usually correlated with higher Treasury yields because they usually correspond to periods of healthier economic activity and therefore lower credit risk. However, this time low spreads are occurring at a time when Treasury yields are at their lowest levels.
Likely investor returns
To help determine whether there is irrational exuberance in the high-yield bond market, Altman and Harmon built a cash flow model to measure the returns that would be available to investors if future default rates and recovery rates were to fall in line with historical averages. They found: “If an investor were to buy a representative portfolio of CCC-rated bonds as of the peak date of July 6, 2021, and if default and recovery rates were to fall in line with historical averages, we estimate that that portfolio would produce an annualized investment return of 1.7% over 10 years. This compares with the yield on a 10-year US Treasury bond at 1.4% as of that date and thus does not offer much in the way of a premium for the risk taken on by the investor.” If we subtracted the expense ratio of a high-yield fund and included an estimate for transactions costs, the premium would surely have been negative. And that assumes defaults and recoveries occur at historical averages. However, Altman and Harmon noted: “Although future economic conditions are uncertain, the fact that corporate debt and leverage ratios have reached record levels is indisputable.” They added that “the risk profile of this debt is increasing because the amount of debt relative to company cash flows, as measured by the gross leverage ratio, is at elevated levels.”
Altman and Harmon added this caution as well: “Another factor is that the capital structures of high-yield issuers contain much more debt ranked senior to these bonds relative to their cash flows than they have in the past. When this occurs, for a given firm valuation, there will be less residual value upon a default to provide a recovery to high-yield bondholders.” They added: “Over the past decade, covenant protections in both leveraged loans and high-yield bonds have decreased dramatically. Roughly 80% of the US institutional leveraged loan market is covenant-lite, containing little or no maintenance covenants to protect investors from a material degradation in borrower performance. From a high-yield default rate standpoint, this is a mixed bag. On one hand, light covenant levels in loans that are senior to high-yield bonds means there will be fewer cross-defaults, in which the senior lender calls a default related to a covenant violation that triggers a default in the bond. On the other hand, the lighter covenants mean that borrowers can layer more debt on top of the unsecured bonds than they could in past cycles, putting the high-yield bondholder in a more precarious position from both a future default and future recovery perspective.”
Their findings led Altman and Harmon to conclude: “The expectations built into the current market appear to be aggressive and highly optimistic, but not necessarily irrational.” They added: “That said, by underwriting to a set of possible outcomes at the bullish end of the probability curve, investors appear to be making a bet that is highly asymmetric to the downside. What does this mean? In our mind, it means that there are more potential scenarios for investors to underperform expectations than there are for investors to overperform, on a probability weighted basis.” Forewarned is forearmed.
Investors who seek higher returns than are available on the safest bonds and have the ability, willingness and need to take incremental risk should be aware that the yields on publicly traded credit currently are historically low – at a time when their risks are increasing due to greater use of leverage combined with lighter covenants, the Federal Reserve is about to begin tightening monetary policy and the risks of rising inflation have increased. For those investors willing and able to accept limited liquidity (and anyone not withdrawing more than the required minimum distribution from their IRA accounts should be able to do so), the private debt markets appear to offer far superior risk-adjusted returns. And thanks to the SEC’s approval of interval funds, investors can gain access to funds such as CCLFX. The choice of manager here is critical, as they will be determining the credit quality of the portfolio. Cliffwater advises on over $75 billion in assets on behalf of 51 clients (large institutional investors).
With yields on five- and 10-year Treasuries at about 1.2% and 1.6%, respectively, investing in interval funds may provide the benefits of higher yields while also eliminating the duration/inflation risk investors are concerned about. And with equity-like expected returns but only a small fraction of the volatility and downside risk of equities, that incremental credit risk appears to be well compensated.
It is important that you keep at least some percentage of your portfolio in the safest bonds, regardless of their yields, because if the left tail risk to stocks appears, they could turn out to be the best-performing assets in your portfolio. You can use their increased valuations to rebalance your portfolio, allowing you to buy riskier assets when their prices are depressed and expected returns are much higher.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners. He owns CCLFX in his personal accounts and Buckingham recommends it to its clients.
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