Like investing itself, there seems to be a lot of misinformation circulating about diamonds. One of the most predominant inaccuracies concerns the origins of the gleaming gemstones. For reasons unclear, (though some blame Superman), many believe that coal turns into diamonds under high pressure. The problem with this? Most diamonds were created billions of years before multicellular organisms populated the globe…thus, before coal. No, the vast majority of the diamonds we see were formed in the Earth’s mantle under extraordinary pressures and temperatures at least a billion years ago, and then later they were sent to the surface via volcanic activity. Very unique circumstances, no doubt.
Mass misunderstandings are not limited to rare gemstones – compression in corporate bond markets is driving many investors to reach for yield, looking for home runs, but what they are really doing is picking up pennies in front of a steamroller.
Compression in the High Yield Market
The High Yield (HY) market is trading within 25 basis points of the all-time lows in spreads, per source Bloomberg L.P., an environment where investing feels like picking up pennies in front of a steam roller. But even at these paltry levels, HY offers one of the last remaining pockets of positive real yields for investors. It is also enjoying a dramatic decrease in defaults, now under 2% from over 6% at the end of 2020. And, like most other markets, it benefits from continued Fed liquidity support.
What does this mean for investors? There are still positives in High Yield; the quality of the market overall has improved with BBs accounting for 52% of the market, an all-time high, per source Bloomberg L.P. The premium over treasury yields in % terms is relatively attractive by historical measures—still close to 300% (debate about artificially low treasury rates is important here but beyond the scope of this note). In short, we believe that focusing on the downside risks in this type of environment is paramount. Bond selection is key and avoiding losers in compressed markets is acutely more important than picking winners.
Importantly, investors are not being compensated for buying longer maturity bonds. Extra yield—that was historically awarded to investors who took on additional duration risk in the High Yield Market—is at all-time lows, as seen below.
This chart shows historical yield divided by duration in the HY market:
Starved for yield, investors may be tempted to take on additional credit risk by increasing lower-rated allocations, particularly to CCCs. The timing of such allocations would be questionable, however. As shown below, CCC spreads are nearly 40% tighter from pre-pandemic levels, while BBs are unchanged and Bs are only slightly tighter
BB-CCC OAS Compression from 2001 thru 2Q21
Over the past 20 years, taking on CCC-rated risk (and the associated increase in compensation) from B-rated risk has provided an additional 476 bps of forward-looking yield. At the end of the second quarter of 2021, that number was a paltry 212 bps, however.
There may well be a couple of more years of Fed accommodation and negligible defaults, but no one will ring the bell when it’s over. In the meantime, this unique, yield-compressed environment may last longer than expected. Now is not the time to pick up pennies in front of a steamroller; it is the time to position portfolios to avoid the losers.
New Age Alpha is ushering in a new age of asset management by applying an actuarial-based approach to investment portfolios. Utilizing these principles built by the insurance industry, we construct portfolio solutions, indexes, and tools that aim to identify and avoid a mispricing risk caused by investor behavior. Embedding well-established principles of probability theory in our investment methodology, we construct solutions that aim to avoid overpriced securities in a portfolio—losers. We combine the alpha potential of active management with the advantages of rules-based investing to build differentiated equity, fixed income and ESG-themed portfolios that drive long-term outperformance.
New Age Alpha refers to the New Age Alpha separate but affiliated entities, generally, rather than to one particular entity. These entities are New Age Alpha LLC and New Age Alpha Advisors, LLC (“New Age Alpha Advisors”). Investment advice is offered through New Age Alpha Advisors, LLC a wholly-owned subsidiary of New Age Alpha LLC. New Age Alpha Advisors is an investment advisor registered with the U.S. Securities and Exchange Commission. New Age Alpha Advisors, located in the State of New York, only transacts business in those states in which it is properly registered or qualifies for an applicable exemption or exclusion from such state’s registration requirements.
This material should not be construed as an offer to sell or the solicitation of an offer to buy any security. It is not possible to invest directly in an index. We are not soliciting any action based on this material. It is for general information purposes only. To the extent that it includes references to securities, these references do not constitute a recommendation to buy, sell or hold such security, the information may not be current, and it should not be read to suggest that it is an endorsement of New Age Alpha or its products or strategies. There is no intention for New Age Alpha to include any securities referenced herein, if any, in its portfolios unless they become part of the established universe of eligible securities that are part of each specific investment strategy.
Past performance is not indicative of future results. Current and future results may be lower or higher than those shown. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended and/or purchased by New Age Alpha), or an Index, product, or a referenced strategy, either directly or indirectly, in this material, will be profitable or equal to corresponding indicated performance levels.
Any charts, graphs or tables used in this document are for illustrative purposes only and should not be construed as providing investment advice. Information contained herein does not reflect the actual performance of New Age Alpha’s products or portfolios. All research and data is simulated, does not give effect to any fees or costs of trading and should not be considered indicative of the skill of New Age Alpha.
Information contained herein and used in the analysis provided by New Age Alpha has been obtained from sources believed to be reliable, but not guaranteed. It has been prepared solely for informational purposes on an “as is” basis and New Age Alpha does not make any warranty or representation regarding the information. Investors should be aware of the risks associated with data sources and quantitative processes used in our investment management process. Errors may exist in data acquired from third-party vendors.
All New Age Alpha trademarks are owned by New Age Alpha LLC. All other company or product names mentioned herein® are the property of their respective owners and should not be deemed to be an endorsement of any New Age Alpha product, portfolio or strategy. This overview is limited to providing general information about New Age Alpha and its investment advisory services. New Age Alpha’s specific advice is given only within the context of its contractual agreements with each client. Investment advice may only be rendered after the delivery of Form ADV Part 2 (an investment advisor’s disclosure document) and the execution of an investment agreement by the client and New Age Alpha. New Age Alpha’s Form ADV Part 2 and accompanying descriptions are available upon request.
CC NAA10264 SKU 10132