CAN EQUITY INDEX FUTURES HEDGE HIGH- YIELD DEBT RISKS?


High-yield bonds and equities have had a stellar decade since hitting bottom in March 2009, delivering returns of over 200% and 300%, respectively (Figure 1). On a risk-adjusted basis, high- yield bonds delivered better returns than equities from 2009 until 2013. Since then, equities have taken the lead. High-yield bonds are beginning to struggle for three reasons:


• The yield curve is flat – and even inverted from 0-5 years – reducing carry and rolldown.


• Credit spreads are historically tight, capping upside, and limiting carry and rolldown (Figure 2).


Source: Bloomberg Professional (LF98TRUU and SP1)


• Credit spreads have begun to widen, causing high-yield bond indices to underperform stocks.


What’s most worrisome about the state of the high- yield market is the historical relationship between the easiness or tightness of monetary policy and later returns in high-yield bonds. Past monetary tightening cycles have not been kind to high-yield investors:


1. In the late 1980s, the Federal Reserve (Fed) hiked rates and inverted the yield curve. High- yield bond spreads exploded from 3.5% over Treasuries in 1988 to 10-11% in 1991, sinking the “junk bond” market and its progenitor, Drexel Burnham Lambert.


2. The 1994 Fed tightening cycle had little initial impact on high-yield debt but by 1997, after several years of a flat yield curve, spreads began to widen, leading to a sharp underperformance of the high-yield debt market in the late 1990s and early 2000s (Figure 3).


3. The Fed’s 2004-2006 tightening cycle also had little immediate impact on high yield debt but in mid-2007 spreads began a sudden and dramatic widening that coincided with the global financial crisis (Figure 4).


Figure 1: After a Stellar Decade, High-Yield Bonds are Beginning to Fall Behind Equities.


Figure 2: Tight but Widening Spreads and a Flat Curve are Toxic for High-Yield Bonds.


Source: Bloomberg Professional (USSW10, USSW2 and LF98OAS)


24 | ADMISI - The Ghost In The Machine | September/October 2019


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