What to Buy First

This could be best buying opportunity in bonds since 2009

By: Greg Obenshain

We are in times of great uncertainty about our economy and our country.  We don’t know the duration or the depth of the economic impact of the coronavirus.

But we do know that the stock and bond markets have had their biggest drawdown since the 2008 financial crisis. We believe the sheer speed of the drawdown is in the process of creating a once-in-a-decade buying opportunity. 

But even though we know how cheap the market is, and how much pessimism is priced in, we also know how difficult it is psychologically to start buying when the fear of further drawdowns is on everyone’s mind.  We know that in 2008, stocks went down another ~20% after falling as much as this market has fallen.  And our study on crisis investing suggests that the best time to buy has been 2–3 months after high-yield spreads hit 6%, which would imply late May to early June.

So what is the best way to start buying? What should investors buy first to capitalize on this dislocation?

We think the credit markets, and parts of the high-yield market in particular, are an attractive place to deploy capital right now. Today, the high-yield bond market as a whole is yielding a remarkable 10.9%, while the highest-quality high-yield category (BB credit) is yielding 8.7%. For context, the average yield on the high-yield index from 12/31/2009-12/31/19 was 6.7% and BB was 5.2%. Riskier credit has repriced dramatically since January.

Figure 1: Yields on Investment-Grade and High-Yield Credit

Source: Bloomberg Barclays US Corporate Indices

As in equities, the sell-off in high-yield has been one of the fastest on record. High-yield spreads are now at levels not seen since 2009, according to our research.

Figure 2: High-Yield Spread at Recession Levels

Source: Bloomberg Barclays High Yield Index

Unlike equities, bonds are contractual obligations with set coupons and maturity dates. Unless they default, their returns are known. Even in default, bonds typically do not lose all their value.

While the range of uncertainties involved in equity valuation is vast, credit valuation is often a tractable problem even in times of great uncertainty. A few relatively simple inputs are all that is needed to price a bond – unlike the growth forecasts and discount rate assessments that make equity valuation notoriously tricky.  Here, for example, is our estimate for credit returns over the next two years. The below assumes that 21% of high yield defaults over two years. The highest historical 2-year default rate according to Moody’s data since 1970 was 19% in 1990 and the next highest was 17% in both 2001 and 2009.

Figure 3: Our Expected Returns for Credit

Source: Verdad estimates. Assumes credit spread normalizes over a two-year period.

Are we certain of the above returns? No. But base rates from previous selloffs suggest to us that credit could likely deliver positive returns quickly and be an easier initial investment than equities.

This type of math might explain why high-yield had historically had limited downside after the initial selloff and positive returns within 12 months even when equity markets remained highly volatile. To get a sense of how situations like this have played out in the past, we looked at four previous periods of market sell-offs to see how high-yield bonds performed from a similar point to where we are today.

Figure 4: High Yield Performance after Sell-Offs

Source: Bloomberg

Based on our observations, high-yield tended to stabilize soon after the initial drawdown and was almost always positive within 12 months.

Entering 2020, the problem for pension funds and retirees was yield, which had led to the explosion of products to deliver yields well in excess of available treasury returns. We have been consistently negative on this idea. In May, we wrote a piece called “Fool's Yield,” arguing that the incremental yield available when investing in the lower-rated portion of the high-yield market had base rates of degradation and loss that negated that extra yield. In January, we wrote another piece called “A CCC Opportunity?” warning that CCC bonds were a horrendous trade.

Now, the situation is dramatically different. The fool’s yield, the point beyond which there is little incremental benefit to taking more risk, is now likely in the 7% range, after excluding energy and seriously challenged credit that has yet to be downgraded. This is coming very close to the return targets of many pension funds. As importantly, the incremental yield for taking more risk has now repriced in the right direction.

We think investors should strongly consider allocating to the high-yield bond market right now.  7% yields on BB bonds don’t come along every day, and volatility in credit is much lower than in equities. 

P.S. For more of our thoughts on credit markets, please see our previous pieces, “Beating the Index in Bonds,” “Does Factor Investing Work in Bonds?” and our recent piece “Crisis Investing” which includes an entire section dedicated to bonds.