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A late-cycle approach to high yield

A late-cycle approach to high yield

11-06-2018 | Insight

Has the time come to adopt a more defensive approach to high yield? The structure, breadth and complexity of the high yield market make it a challenging environment for investors. But it also offers attractive returns compared to other credit segments and high yield bonds receive a fixed allocation in many portfolios. As timing the peak of the market is notoriously difficult, what are the options for managing the high yield allocation in the later phases of the credit cycle?

  • Johan Duyvesteyn
    Johan
    Duyvesteyn
    Senior Quantitative Researcher and Portfolio Manager

Speed read

  • Liquid, flexible and low-cost access to the high yield market 
  • Proven model-based timing strategy 
  • Defensive in nature with more stable returns over the full credit cycle

Robeco Dynamic High Yield offers a solution to this quandary. This is a strategy that enables investors to maintain high yield exposure, while outsourcing the ‘timing decision’. It does this by reducing risk when spreads are expected to widen and the high yield market looks bearish, or by increasing exposure if spreads look set to tighten and prices to move higher.

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Timing strategy based on proven quantitative model

Decisions on when to dynamically adjust exposure are fully based on the signal from a proprietary quantitative market-timing model, which is rooted in academic research. The model applies various fundamental, well-established and technical variables to forecast credit returns, including macro factors and equity market trends. 

By systematically adjusting the investment portfolio according to the model’s signals, the strategy avoids well-known human behavioral biases and can even benefit from them. When markets are driven by investors’ emotions, the model sticks to the fundamentals.

Alternative access to the high yield market

The high yield corporate bond market lacks the liquidity of the equity or developed government bond markets, so it can be difficult for investors to move in and out of it rapidly. As this strategy focuses on market timing, it requires this flexibility and thus uses credit default swaps (CDS) to gain high yield exposure rather than buying individual high yield bonds.  

Investing in a CDS index means buying one single market instrument to gain a broad high yield exposure. No bottom-up issuer selection is required, differentiating this approach from traditional fundamental high yield approaches. The CDS indices the strategy uses are well-established, cover a representative range of issues and are regularly rebalanced, thus ensuring their quality in terms of liquidity and diversification. Trading these indices instead of individual bond issues offers flexibility in terms of trading volume and enables portfolio changes to be implemented quickly while keeping transaction costs down.

‘A liquid high yield solution that dynamically allocates market exposure’  

At times of market turmoil, when high yield bond returns can be hit severely, the impact on these more liquid instruments is less extreme and drawdowns are historically less severe. While the lower liquidity of cash bonds increases risk, this is not rewarded with higher returns. So in this respect, CDS indices are able to deliver more stable returns over time and offer a better risk-return ratio than the global high yield bond index.

Limited drawdowns

As the chart below illustrates, the Dynamic High Yield strategy’s performance somewhat lags that of the high yield bond market in bull markets. But its strength lies in the combination of the timing element and the CDS exposure and the protection this offers in bear markets; a factor which can be particularly significant in a volatile segment like high yield.

Bull and bear market performance since October 2001

Sources: Bloomberg Barclays, Robeco Quantitative Research. Simulated returns for the strategy before its live track record (from 10/2001 to 03/2014) and Robeco QI Dynamic High Yield, IH EUR share class over its live track record (from 04/2014 to 04/2018). All figures in EUR and gross of fees but net of transaction costs. In reality, costs (such as management fees and other costs) are charged. These have a negative effect on the returns shown. The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future. The definition of bull and bear markets respectively are the top and bottom 50% of calendar quarters based on high yield bond market returns.

In bear markets, including the market corrections of 2002, 2008 and 2015, the cash high yield bond market suffered more acutely than the CDS indices. For example, in 2008, when the market plummeted, falling around 29%, the losses incurred by the more liquid CDS indices were much smaller and the strategy lost only 2.1%. Although high yield bonds recovered more strongly, as is reflected in their higher return in bull markets, both the CDS indices and the strategy posted higher returns over the period as a whole.

Dynamic but defensive

As a quant high yield approach, Robeco’s Dynamic High Yield strategy can function as a style diversifier. For example, it offers investors in traditional high yield strategies an alternative way of gaining high yield exposure. It is also suitable for tactical investors as it offers the flexibility to make short-term decisions and more effectively time high yield exposure. 

But in the current market environment, the most compelling argument for this strategy lies in its ability to offer high yield exposure in a more defensive way. It is a solution that combines less risk, lower costs and more stable returns. It has outperformed in bear markets and addresses the liquidity concerns sometimes associated with weaker high yield markets. These attributes result in a superior risk return profile and a higher Sharpe ratio over the credit cycle as a whole.

For more on Robeco’s quant high yield bond strategies, also read ‘Robeco launches Multi-Factor High Yield fund’.

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