As negative yielding global debt breaks a new record by surpassing $17 trillion, investors have never had more difficult conditions in the pursuit of yield, let alone positive yields on a real basis. In this endless search for yield, investors are being pushed further out on the risk curve of investing in high yield bonds and stocks. In fact, many investors are shunning bonds altogether and for good reason as they are now being deemed “return free risk.” Do investors need to take the significant risk of owning nearly all equities to achieve attractive returns or is there a way to invest in bonds, capture positive real yields, and control for risk?
Since 1986, the Bloomberg Barclays US Corporate High Yield Bond Index has compounded at 8.30% with a maximum drawdown of 33.31%. The asset class has produced attractive returns on a risk adjusted basis that have benefited from a near four-decade environment of falling interest rates. However, a 33% drawdown during the Global Financial Crisis is difficult to stomach on the fixed income component of an investment portfolio.
| CAGR | Std Dev | Max Draw Down | Sharpe Ratio | Sortino Ratio | US Mkt Correlation | |||
| Bloomberg Barclays US Corporate High Yield Index | 8.30% | 8.49% | -33.31% | 0.61 | 0.88 | 0.64 | ||
| S&P 500 Index | 10.82% | 15.21% | -50.97% | 0.55 | 0.80 | 1 | ||
We have discussed the concept of trend following periodically in this blog as the process of protecting capital during periods of increased volatility and avoiding drawdowns by moving to treasury bills when the trend turns. If we apply a tactical trend following algorithm to the High Yield Index, we can modestly increase the return but more importantly reduce the maximum drawdown by 50%, reduce volatility as measured by the standard deviation of returns by nearly 30%, and further decrease the correlation to the S&P 500 Index. During bear markets, asset classes can become highly correlated and trend following acts to reduce drawdowns and thereby decrease correlations at critical junctures. While a significant enhancement and proof of concept, the drawdown remains high and investors cannot invest directly in the index.
| CAGR | Std Dev | Max Draw Down | Sharpe Ratio | Sortino Ratio | US Mkt Correlation | |
| Bloomberg Barclays US Corporate High Yield Index with Trend Following | 9.21% | 6.03% | -16.66% | 0.95 | 1.71 | 0.46 |
| S&P 500 Index | 10.82% | 15.21% | -50.97% | 0.55 | 0.80 | 1 |
An alternative to investing in High Yield Bonds via ETFs, is through an ensemble of high yield funds. There are numerous pitfalls to navigate when building and testing trend following strategies on groups of funds such as sample size, stress testing, robustness of signals, and optimization. Tactical strategies must be robust to prove efficacious in the future. In utilizing an ensemble of funds, the opportunity exists to capture fund manager idiosyncrasies and increase the granularity of trend following signals. The application of a trend following algorithm across an ensemble of high yield funds allows for the additional reduction of risk as measured by standard deviation and a major improvement in peak to trough drawdown to just under 6%.
| CAGR | Std Dev | Max Draw Down | Sharpe Ratio | Sortino Ratio | US Mkt Correlation | |
| Tactical High Yield Strategy | 8.37% | 5.05% | -5.78% | 1.09 | 2.03 | 0.48 |
| S&P 500 Index | 10.82% | 15.21 | -50.97 | 0.55 | 0.80 | 1 |
High Yield Bonds are perhaps the last fixed income sector capable of delivering real yields in a compressed interest rate environment. However, buying and holding high yield bonds comes with significant risk in an unprecedented environment. While we cannot expect historical returns of the same magnitude in the future, applying trend following strategies across high yield funds gives us the potential to capture attractive real yields and more importantly control for risk.