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.