GMO High Yield Strategy

Misguided investor efforts to time the high yield market can lead to some of the most straightforward opportunities to deliver alpha. Shorting bonds is a cumbersome process, so investors who are trying to express the view that returns will be poor in high yield markets tend to use index and ETF products. When there is high demand to short these instruments, the borrowing costs can become quite high.

We routinely exploit this investor behavior by either buying and lending out high yield ETFs or entering total return swaps that pay the index’s return plus a considerable spread. Fundamentally, we are not taking any additional risk here because we hold exactly the benchmark exposures; technical risks (such as counterparty or trading/liquidity related risks) could possibly hamper our ability to capture the full discount.

While these opportunities ebb and flow, they can offer a repeatable alpha over the index that at times can be in the 1-3% range. When we see such opportunities, we are very happy to forego other means of trying to add alpha for the repeatable win. 

Another classic hedging strategy that market-timers utilize is buying protection on a credit default swap index, such as CDX HY, intending to insulate themselves from credit losses across a basket of high yield securities. These swaps can seem appealing, as the carry cost of the synthetic vehicle (CDX HY) generally looks lower than the credit spread on the high yield bond index. However, this yield advantage for the cash bonds is misleading.

Not only is CDX HY a higher quality basket of issuers than the typical high yield bond index (with fewer historical defaults), but it also has meaningfully different slide, or roll-down, characteristics. (Slide refers to the profit and loss (P&L) an investor makes when spread or yield curves are upward sloping and the simple passage of time creates price appreciation as the instrument ages into a lower discount rate.)

Hedging-focused investors prefer to buy protection linked to the on-the-run CDX series, which often has a steeper spread curve than cash high yield bonds. Thus, an investor offering protection through these securities can often earn a return higher than the high yield index despite the spread to maturity of the synthetic instrument being lower.

In periods of high market volatility, CDX HY may at times sell off more than the cash bond market. While this creates a more attractive opportunity looking forward, there may be a near-term hit to P&L, relative to the benchmark. A keen eye on market dynamics assists us in understanding dislocations, and therefore, how to best profit from them.

There is also the risk that portfolio differences between CDX HY and the cash benchmark could lead to some idiosyncratic events (e.g., issuer defaults). This risk can be mitigated by adhering to well-defined issuer limits and having a holistic view of the Strategy’s exposures, including look-through into portfolio products.    

Therefore, an investor that can consider and manage the tradeoffs between spread carry and slide (i.e., roll-down) will be positioned to take advantage of this structural market inefficiency.

Much of the high yield cash bond universe is callable – meaning issuers have the right but not the obligation to purchase the bond at a preset price prior to the bond’s maturity. This call option that the investor has sold to the issuer can limit the investor’s upside in a bullish scenario and has the potential to make a bond moderately or even very negatively convex. 

We believe high yield investors do not always get compensated appropriately (through a higher base case spread premium) for taking on this unattractive “heads I barely win, tails I lose big” profile. Indeed, our research shows that the most negatively convex high yield profiles have, on average, worse return outcomes than the broader high yield universe. We posit that pockets of the high yield investment community (e.g., indexers) may focus on scenarios in a flat spread or interest rate environment and do not adequately account for how the durations of negatively convex bonds can move against the investor when yields move up or down, generating inferior P&L outcomes.

We actively avoid owning the most negatively convex profiles on the cash bond side, which, when combined with our exposure within CDX HY (derivative contracts are not callable), generally gives us a superior convexity profile compared to the high yield universe as a whole. This strategy results in a slightly higher duration on average than the cash benchmark, which may result in some excess volatility, particularly during moderate market moves. However, the Strategy’s defensive tilt, due to the additional exposure to quality bonds, offsets this risk.

Investors’ obsession with achieving maximum yields offers other further opportunities for us to outperform. While from the outside all junk-rated debt may seem the same, it is in fact a very heterogeneous universe. CCC bonds default at a rate of 15% or so on average across a market cycle, while BB bonds default at around one-tenth that rate. BB bonds have vastly less credit risk than their CCC counterparts and therefore yield substantially less – on average about 6% less. But given the huge disparity in credit losses between those groups, the lower-risk, lower-yield BB group has actually outperformed over time.

While this phenomenon is somewhat similar to the counterintuitively strong performance of high-quality stocks, the effect is even more striking in high yield. BB bonds have on average delivered 2.9% returns over Treasury bonds since 1988, whereas CCC bonds have delivered a mere 1%, and they have done so with a return volatility of 7.4%, just a little over half of the 14.3% volatility of the CCC cohort.

BB bonds are not always priced attractively versus the rest of the high yield universe, but when they are, they offer another attractive way to outperform, in this case with the side benefit of lower fundamental risk. While this is generally the case, in an aggressive rally, an investor who has avoided these high-beta CCC rated bonds will miss out. We analyze the valuations of different credit rating buckets to help us effectively capture this inefficiency.