An improbable level of calm in markets has compelled investors to capitalise on low levels of volatility. Here we assess why they should actively manage risks in high-yield credit.
It is important to look beyond the headline indicators of risk. Stubbornly low yields and low volatility in recent years have compelled yield-seeking investors to increase their allocations to high-yield bonds. This year the volatility of high-yield credit has fallen below that of investment-grade credit (see Figure 1). But there is no reason to believe that low volatility is the new normal. Even though market conditions are stable, investors should appreciate the latent risks.
Figure 1. Volatility of high-yield credit compared with that of investment-grade credit
Source: Hermes Investment Management as at July 2017
Stretching for yield
Analysing stretch risk allows us to identify assets that trend in a positive direction for a considerable period of time, suppressing volatility, and obscuring the true underlying risk. In credit markets, high-yield bonds have lower credit ratings than investment-grade credit, and therefore, a higher risk of default. As such, investors must look for stretch risk in their credit exposures.
Not only are many investors allocating more of their portfolios to high-yield bonds in an attempt to achieve yields similar to those realised by investment-grade debt before the global financial crisis, some multi-asset credit funds have a greater allocation to high-yield bonds than would previously have matched their intended clients’ risk appetites.
Investors should not rely on the current ex-post volatility of high-yield credit to justify their growing allocations. This low-volatility environment in high-yield credit is far from the status quo: we believe that it is unprecedented. Over the long term, high-yield is undoubtedly more volatile than investment-grade credit.
A turning point
Conditions could remain stable for some time – but they might also soon change. The Federal Reserve has raised interest rates twice this year, and Janet Yellen has said that the central bank could start to unwind its bloated balance sheet “relatively soon”.
Such moves towards monetary policy normalisation would increase the volatility of high-yield bonds, and investors that have taken on additional risk may struggle to reduce their oversized positions. Forced selling could ensue, and many investors would be focused on exiting positions rather than taking advantage of opportunities to enter or add to exposures.
The reality of risk
Investors should not rely on volatility being the primary metric used to gauge the risk of a particular instrument. The credit quality of the underlying issuer and the instrument itself also provide a valuable forward-looking perspective, helping investors reach a comprehensive view of the risks associated with the instrument.
Managing allocations to high-yield credit
To achieve an attractive yield without taking on the risk associated with a significant allocation to high-yield bonds, investors must actively manage the size of their positions. To do so, it is important to have a flexible, risk-focused mandate and an emphasis on risk management beyond company selection.
Among the risk metrics we use when sizing our positions are the credit quality of an instrument and its issuer, and its historic volatility of up to 10 years. Each position is based on its unique risk characteristics, such as credit rating, cash price, and the cyclicality of the business in question.
While it is easy for yield-seeking investors to become complacent in their allocations to high-yield credit, they must remember: actively managing allocations to high-yield credit is important, regardless of market conditions.