‘Selection’ is often the keyword when planning to invest in high yield bonds. But is this really the best way to generate performance in this asset class?
High yield bonds, which benefit from one of the best long-term risk/return ratios among listed financial assets, are increasingly integrated into multi-asset portfolios. Their advantages include short duration, good sectorial balance, low overlap with equities and attractive yield, as well as a favourable macroeconomic situation. The asset class is attracting the attention of an increasingly large number of investors wishing to make capital of these advantages by relying on fundamental management, focused on bond selection. This is motivated by the maximum losses (max drawdowns) frequently observed for this type of bond. There are indeed significant, impromptu and, above all, common tumbles in this universe. Therefore, the idea that deep fundamental analysis is necessary to anticipate these leaps is quite natural. We can also think that the high-yield bonds market is less efficient and lends itself even more to human analysis. However, this point of view is not always reflected in the reality, with an overwhelming majority of fundamental managers underperforming global indices.
First, bond falls are very violent, and analysts have great difficulty in anticipating these price breaks. These dynamics are reinforced by the binary side of debt refinancing, but also by a human psychological bias of positivism and hope. Liquidity, which is sometimes deficient, constrains management and reduces the performance of non-negligible and highly variable transaction costs. The complexity of this segment of bonds makes the fundamental analysis difficult and adds another dimension to the management. Finally, the size of the companies composing the universe, which are smaller than those represented in the equity indices, makes the information issued less standardized.
How can we approach this market in a different way?
One of the answers could be broad diversification. Diversification has the enormous advantage of eliminating idiosyncratic risk while allowing one to benefit from the distinctive features of the segment. In order to do this, we need to consider the entire universe. First, by taking the largest universe available, we get global exposure with diverse growth patterns and geographic areas. This brings a lot of robustness to the portfolio. The second consequence of diversification is the consideration of non-tradable securities because they are not liquid. This partial illiquidity of the universe can be tackled by an optimised sampling technique, allowing investors to have the same risk profile as the universe with a liquid portfolio. Finally, the third point is the need for advanced risk management. In order to examine more than 4000 securities, as in the ICE Global High Yield index, a robust and precise quant approach is necessary for risk management.
An ultra-diversified quant approach, therefore, has significant benefits for the investor. Finally, the quant revolution does not seem to be affecting only this market, which was reserved until now to human analysis.
Entretien avec Grégoire Pennone, CEO de ONE swiss bank. La banque a fortement amélioré son ratio coûts-revenus au cours des douze derniers mois et enregistré des afflux nets positifs au premier semestre.
Thanks to prudent management decisions, we were able to minimise the negative impact of the market turmoil and meet our initial expectation for H1 2022, except in terms of AuM.
Ongoing Covid 19 outbreaks (still met with harsh restrictions in China), dreadful geopolitical tensions, continuous reassessment of recession risks make if difficult to navigate highly volatile financial markets. In these troubled circumstances, investors should avoid emotional reactions to abrupt market gyrations and focus on fundamentals and long term potential of financial assets.