High Yield, Low Yields, and My Dear Aunt Sally

Konstantin Tourevski, CFA, Head of Fixed Income
Apr 29, 2021 12:34:45 PM 8 min read

Leave it to Facebook and Twitter to make math controversial. While much on social media is odious or downright hateful, it’s hard not to appreciate the platforms’ abilities to make the most seemingly ordered things acrimonious. For example, most people have seen some variant of the mathematical expression below in their various feeds:

8 ÷ 2(2+2)

The operation is designed to elicit divergent answers, each from readers claiming to know for certain that he or she is correct. Some insist the answer is 1 while others maintain the answer is 16. Well, as is often the case in these matters, the devil is in the details.

This is because some use the BODMAS order of approach to math (Brackets – Orders – Division – Multiplication – Addition - Subtraction). Please Excuse My Dear Aunt Sally for using an equally valid alternate approach, however. As in: PEMDAS (Parentheses – Exponents – Multiplication – Division – Addition – Subtraction). The important distinction with the PEMDAS method, however, is that the respective groups of (Multiplication – Division) and (Addition – Subtraction) take equal priority and defer to the left-to-right order of the equation. Each approach is correct yet, in the expression above, the former method arrives at 1 (AKA “8 ÷ 8”), while the latter method arrives at 16 (AKA “4(2+2)”). So, which is correct? Well, in this case—due to a structural error in the expression—both are correct. The use of the division symbol rather than a forward slash gave unclear instructions, thus resulting in different outcomes.

Such is the problem with vague and ambiguous information.

Just Follow the Numbers

A lesson can be learned here with regard to one’s investment portfolio and error avoidance. High yield bonds are trading at all-time lows in yield with the index hovering near 4%:

Bloomberg-Barclays

One can argue endlessly about whether these levels are appropriate or not or where we can go from here, but one thing is certain: If you are going to invest in the High Yield market at these levels, avoiding losers is more important than ever.

This is simply math. On the one hand, investors may earn the coupon and even a little capital appreciation if yields fall further, but the upside at these levels is severely capped. On the other hand, credit losses are still lurking for companies that are unable to generate performance expected by the markets. With yields this low and defaults falling again, investors may get complacent and sloppy in their name selection when, in fact, they should be laser-focused on keeping losers out of their portfolios.

Similar to those devils in the details described in the math equation earlier, it’s vitally important to examine the question posed rather than simply rushing to an incorrect answer. In this manner, investors need to strip out the vague and ambiguous information to avoid the risk of human behavior. At New Age Alpha, we’ve created the Human Factor to do exactly that.

The Human Factor measures the probability a company will fail to deliver the growth implied by the security price. Unlike a traditional portfolio manager, we take an actuarial-based approach similar to those used by insurance companies to manage risk. We focus only on known information, rather than unknown.

Does the Human Factor matter in this tight market that, many believe, prices in so little risk? It certainly does. We looked at the 100 largest issuers in the High Yield market and highlighted 10 companies whose bond complexes currently generate near index level yields but have dramatically different Human Factor scores. High Human Factor scores suggest a high likelihood of failing to deliver growth implied by their stock prices and, by extension, expected by bond investors.

H-Factor-NAA

H-Factor Data: Provided by New Age Alpha as of 3/26/21
Bond Outstanding Data: Provided by S&P® as of 3/26/21
Average Yield to Worst: Provided by Bloomberg LP and New Age Alpha as of 4/13/21

Look at it this way: the total value of a company is comprised of both debt and equity. Bond prices, like stock prices, are determined by markets and affected by human behavior biases. In simple terms, bonds can be viewed as a combination of the risk-free rate and a sale of a put option on the company’s assets with a strike piece equal to the value of the debt. For companies with high Human Factor or a high probability that investor expectations will not be met, this put option, because it is representative of an overpriced stock, must be underpriced. This also makes the debt overpriced, increasing risk to the investor in the bond. In this manner, we believe Human Factor scores represent the likelihood the security will fail to generate the implied growth. Then we avoid securities with high scores. For more information, we encourage you to read our Whitepaper located HERE

The Critical Methodology for High Yield Investment

It feels like only a matter of time until one of those “tricky” math expressions shows up again in one’s social media feed. And, generally speaking, both the PEMDAS and BODMAS methods can help guide the way. When it comes to the risk of human behavior, however, we believe the best way to mitigate it in your portfolio…and that’s by using the Human Factor methodology to avoid the losers.

About Us

New Age Alpha is a global leader in building actuarial-based asset management solutions that aim to inure investor portfolios against an idiosyncratic risk caused by human behavior. Investors are unaware of this risk that leads to loss, cannot be diversified away, and don’t get rewarded for taking it. Unlike firm-specific risk, which can often be diversified away, this risk affects security prices specifically and we believe is caused by human behavior. Through our research we have identified a differentiated source of alpha that is uncorrelated with traditional risk factors and managers, and as the foundation to our investment approach, we have built a range of actuarial-based asset management solutions that aim to mitigate the risk of human behavior.

Disclosures

Past performance is not indicative of future results. Current and future results may be lower or higher than those shown. It is not possible to invest in an index. An investor utilizing the Human Factor may experience a loss. No client or prospective client should assume that any information presented in this data set serves as the receipt of, or a substitute for, personalized individual advice from New Age Alpha or any other investment professional. All research and data are simulated and should not be considered indicative of the skill of New Age Alpha. The research data presented in this document has been calculated backward in time and is not a contemporaneous record of actual assets managed by New Age Alpha.

The accuracy of the Human Factor is materially reliant on the integrity of the information utilized in the calculations, including any assumptions and or interpretations made by the user about the data. Data discrepancies, and user assumptions, can all contribute to differing outcomes. The underlying assumptions and processes presented herein are subject to change. New Age Alpha reserves the right, in its sole discretion, without any obligation and without any notice, to modify the information contained in this material, or to correct any errors or omissions in any portion of this material at any time.

The above statements are not an endorsement of any company or a recommendation to buy, sell or hold any security. The views stated herein are only current through the date stated and are subject to change at any time based on market or other conditions and New Age Alpha disclaims any responsibility to update such views. Any Human Factor information or charts presented herein or utilized in the Human Factor system are provided for illustrative purposes only and should not be construed as providing investment advice or as a recommendation to buy or sell any particular security. The Human Factor information provided herein is a snapshot taken at a particular point in time and any analysis or information contained in this document is outdated and should not be relied upon as investment advice. Moreover, the information presented in this document may have changed materially from the date on which it was created. New Age Alpha may or may not currently own the securities at the times set forth in this article. There is no intention for New Age Alpha to include these securities in its portfolios unless it becomes part of the established universe of eligible securities that are part of each specific investment strategy (e.g. the S&P 500®). It is important to note that there can be no guarantee that the application of the Human Factor to investment portfolios or certain stocks or securities can produce profitable results.

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