December 14, 2015: High Yield Bonds And Their Correlation With Stocks

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High Yield Bonds And Their Correlation With Stocks

High yield bonds have behaved very weak all year:

High Yield Bond Funds Performance Comparison (as of 12/14/2015):

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR
JNK (SPDR Barclays High Yield Bond ETF)	-8.6%	-5.8%	-0.8%	3.3%
HYG (iShares iBoxx $ High Yield Corporate Bd)	-7.6%	-4.7%	-0.1%	3.7%
HYLD (AdvisorShares Peritus High Yield ETF)	-14.6%	-13.8%	-5.9%	-0.4%
VWEHX (Vanguard High-Yield Corporate Inv)	-3.0%	-1.0%	2.1%	5.6%
SPY (SPDR S&P 500 ETF)	-0.3%	0.9%	14.4%	12.4%

We include HYLD (AdvisorShares Peritus High Yield ETF) as this is one of those high yield bond funds that did exceptionally well in 2012 and 2013 but started to tank in 2014, very similar to TFCIX (Third Avenue Focused Credit Instl) (more about it later). The fund is loaded with many energy related debts and has suffered greatly since oil price dropped.

Recently, as oil price continued to drop and markets are facing an uncertainty on whethe the Federal Reserve posed to raise interest rate, high yield bonds accelerated their downside. The biggest news was that on Thursday last week TFCIX (Third Avenue Focused Credit Instl) announced that it stopped redemption from its investors, due to many illiquid high yield bonds it held. We mentioned the famed Third Avenue value fund TAVFX in our recent newsletter November 23, 2015: Active Stock Fund Performance Consistency.

As of today, the high yield bond carnage continues.

Correlation between High Yield Bonds and Stocks

In the last newsletter June 8, 2015: High Yield Bonds As An Asset Class?, we claimed that high yield bonds should not be treated as a single asset class as it can be a surrogate of a stock and long term Treasury bonds portfolio. If we use our correlation calculation tool listed on Asset Trends & Correlation page, we can see the following correlation between high yield bonds and stocks (using Vanguard High Yield Bond Fund VWEHX and Vanguard 500 Index Fund VFINX):

From the above chart, we can see that for the past 10 years, high yield bonds have been positively correlated to stocks.

Next, let’s see whether high yield bonds have any predictive power on stocks. In the following table, we look at portfolios using high yield bonds VWEHX total return moving average (200 days simple moving average) to signal a buy and sell S&P 500 (VFINX):

when VWEHX total return is above its moving average, buy VFINX (stocks). Else, buy CASH.

We test this using both month end closing prices and week end closing prices:

Portfolio Performance Comparison (as of 12/14/2015):

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR	Max. DD 10 Yr	Since 12/31/91	Max. DD (since 91)
P SMA 200d VWEHX VFINX Monthly	-2.7%	0.1%	10.8%	7.8%	8.0%	22.5%	8.2%	49.8%
P SMA 200d VWEHX VFINX Weekly	6.0%	6.0%	12.6%	9.1%	10.6%	18%	9.1%	52.8%
VFINX (Vanguard 500 Index Investor)	0.1%	3.0%	14.5%	12.5%	7.0%	55.3%	8.9%	55.3%

Max. DD: Maximum Drawdown.

A few of observations:

The weekly portfolio has done better than the monthly one. Year to date, the weekly one has safely avoided the recent weakness in S&P 500 (VFINX) and has returned 6%.
For the past 10 years, high yield bond moving average based stock portfolios have definitely out performed S&P 500, in terms of both total returns and risk (maximum drawdown).
However, when one extends to the whole testing period since 12/31/1991, the two portfolios have behaved in par with the buy and hold S&P 500, even though their Sharpe ratios are still meaningfully higher than VFINX’s and their standard deviations are much lower than VFINX’s (see the detailed comparison table).

If one looks more carefully at the return table data (from detailed comparison table), we see the following:

In fact, from 2000 to 2002, the high yield bond predictive power over stocks faltered badly. The reason: VWEHX did pretty well in those three years. In the three years, instead of positive correlation, high yield bonds were positive while stocks did badly, a very negative correlation. In fact, during those three years of the burst of technology bubble, high yield bonds, small cap stocks and REITs all did well, thanks to the Federal Reserve’s aggressive monetary loosening policy.

So it is really not a sure thing to proclaim high yield bonds are positively correlated with stocks.

As always, we remind our readers that we are not officially supporting or advocating the two portfolios mentioned in our newsletters. These are merely used for study purpose.

What about Now?

First, the situation in 2000-2002 is different from today: at that time, high yield bonds were strong and stocks were weak. This time, high yield bonds have been weak. Or put simply, that situation is not in conflict with today’s high yield bond weakness. When high yield bonds are weak, it might indeed cause trouble for stocks. Here are some plausible reasons:

Oil price is now at 11 year low. The massive oversupply of oil has forced many debt heavy energy companies to shut down their operations. They have a hard time to service their debts. Recent MLP rout (representative one is that Kinder Morgan reduced its dividend by 75%, see wsj report) exemplifies this.
High yield bonds have been issued to many companies that have shaky financial balance sheets. These companies are mostly small and medium size businesses. They are the engine of economy. When they have a debt problem, the damage can be wide spread.
The upcoming possible Federal Reserve’s interest rate raise will only exacerbate the problem.
All of the above can cause even investment grade companies’ debt interest rate go up. The stocks of S&P 500 companies have been largely supported by the biggest buyer — corporations themselves for several years now. Stock buy backs from Apple to Cisco to IBM have propped up their stocks. If this source of stock purchase funding dries up, it is hard to see how stocks can be supported at this hefty valuation level.

To summarize, whether high yield bond weakness is a presage of the stock weakness or not, there is a reasonable doubt on the current stocks’ strength.

Market Overview

There are still two relatively bright spots in the US stock market: REITs and large technology stocks (represented by Nasdaq 100 QQQ, for example) have positive trend scores at this moment. However, as the broad base risk assets all have retreated, it is easy to see that investors are very risk averse at the moment.

For more detailed asset trend scores, please refer to 360° Market Overview.

We would like to remind our readers that markets are more precarious now than other times in the last 5 years. It is a good time and imperative to adjust to a risk level you are comfortable with right now. However, recognizing our deficiency to predict the markets, we will stay on course.

We again copy our position statements (from previous newsletters):

Our position has not changed: We still maintain our cautious attitude to the recent stock market strength. Again, we have not seen any meaningful or substantial structural change in the U.S., European and emerging market economies. However, we will let markets sort this out and will try to take advantage over its irrational behavior if it is possible.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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