On Thursday the VIX closed at its highest level since November after months of benign and complacent market conditions. In the intermittent period of market calm, investors have been turning to high-yield bonds in the low-yield, and seemingly low-risk environment. However, Fraser Lundie, Co-head of Credit at Hermes Investment Management, believes these investors have stretched themselves to take on potentially outsized levels of risk and should look to actively manage the size of these allocations as market conditions evolve.
Fixed income investors have been operating in extraordinary conditions. While yields remain stubbornly low, the upside is that realised risk appears to have similarly declined. In recent months, the volatility of high-yield credit has been lower than that of investment-grade credit, which has maintained a relatively consistent level of volatility since the financial crisis (see chart). Stretch risk allows us to identify assets that trend in one direction for a considerable period of time, suppressing headline volatility to a reduced level, and giving an impression that an asset is less risky than is actually the case.
Volatility of high-yield credit compared with that of investment-grade credit
Source: Hermes Investment Management
This threat is evident today in evolving credit allocations - investors being driven down the capital structure of businesses, with an increasing number allocating a greater share of their portfolios to high-yield bonds in an attempt to source the same yield that they could achieve in investment-grade debt prior to the financial crisis. Meanwhile, some products are now being sold with a greater allocation to high-yield bonds than would previously have been considered appropriate for their intended clients’ risk appetites.
A turning point
However, the numbers that investors have used to justify these rising allocations to high-yield bonds are misleading. The ex-post volatility that is being focused on is a very short-term risk metric, reflecting a recent and historically unprecedented trend. This low-volatility environment is far from the status quo.
Meanwhile, the consistently benign conditions that have lulled investors into feeling secure could be about to change. The rhetoric from central bankers, particularly Janet Yellen, is increasingly hawkish, suggesting that the risk of higher interest rates is increasing. A rise in interest rates is likely to prompt a rise in volatility in high-yield bonds and a normalisation in the relationship between investment-grade and high-yield credit.
Those investors that have stretched themselves to take on greater risk may face a range of nasty surprises. The risk of right sizing positions could put downward pressure on the market due to forced selling. At the very least, these investors are unlikely to have the dry powder to take advantage of opportunities to enter or add to positions at attractive levels should a sell-off occur.
The reality of risk
Over the longer term, high-yield credit is still emphatically more volatile than investment-grade credit and there is no reason to suspect this should change.
The risk of a particular instrument is also not demonstrated by its volatility alone. The credit quality of the underlying issuer and the instrument itself provides a valuable forward-looking perspective, reflecting how that instrument could be expected to perform should market volatility or broader economic conditions deteriorate, based on the fundamental condition of the business. Ignoring credit quality and the difference between instruments sets a dangerous precedent in a portfolio as investors take on significantly more long-term risk.
A solution to the problem
The key to investors achieving much-needed yield without taking on unmanageable degrees of risk from overly large allocations is to actively manage the size of their positions in high-yield instruments. It is essential to have a flexible, risk-focused mandate and an emphasis on risk management beyond company selection in order to avoid the pitfalls of incorrectly sizing allocations.
At Hermes, we size our positions based on the historic volatility and historic risk of the credit type in question, with our allocation flexing according to the changing volatility landscape. This process begins from the point of initiation, with new positions never being sized automatically but rather based on their unique risk characteristics.
While high-yield volatility has trended lower for several years, there is no reason to believe that this is the new normal. Nonetheless, investors have become complacent in their allocations to this area of the market, potentially risking oversized positions that they would be challenged to refocus in the sort of market turn that is starting to seem more likely. It is essential that investors actively manage the size of their allocations if they are to manage their risk effectively.