Author: Investment Services

High Yield Returns When Yield Spreads Are Low

This blog is taken from our January 2017 newsletter discussing yield spreads.

High Yield Returns

The yield differential between high yield bonds and US government bonds is currently only about 3.8%. This indicates that the yield on high yield bonds is paying 6.3%, where 10year government bonds only yield 2.5%.

A normal range for this yield spread is between 3% and 7%.  The lower this number is, the lower the potential returns are.

Looking at what happened in 2004, when we were midway in an economic expansion and the yield spreads were about where they are today, these charts illustrate the returns for the three years following this similar economic period. Total returns for the next few years averaged about 8.5% annually for high yield bonds. If the yield spread continues to drop, high yield bonds should continue to appreciate, but if this spread drops below 3%, a defensive strategy is likely.  Currently the yield spread is 3.33%

*The CSFB High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.

 

Why Use Leverage?

 

Leverage is a tool that most people use on a daily basis without the knowledge they are even using it. Think of a home mortgage, this is leverage. A person is able to put down 15-20% the actual cost of the home and borrow the remainder. That person has now leveraged their money 4-5 times beyond its normal purchasing power.

Spectrum uses leverage in some of our SMA accounts and sub-advised mutual funds to borrow money or increase exposure to potentially increase potential returns when our proprietary models indicate risk is lower and trends are established. Below is a graph showing a sampling of these periods.


Managing high yield bonds has been Spectrum’s core investment strategy since offering investment management services in 1988. We have seen about every scenario possible—war, the great recession, over- and under-valuation, and have had experience in all of them. We understand bonds, and consider them predictable, since we have observed them for over 10,000 days. If we can borrow money at 2% and purchase bonds that yield 7%, we can make a net gain of 5% in addition to the 7% bond yield. This is called “carry trade”. However, we need to have liquidity to exit these positions when they are no longer in an uptrend. Since all the funds we use have daily liquidity, we can use this strategy when appropriate without having to ride out a serious decline. So our philosophy is simply; there are times when it is good to own them, good to stand aside, and even times to consider borrowing money to own more for short periods of time when “the wind is at your back”.

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Spectrum Financial, Inc 2023