Should You Go Active With High-Yield Bonds?

In mid-February, the Financial Times reported that the latest round of junk-bond deals carried the largest slug of debt rated CCC or lower since 2007. The article (subscription required) covered only the first six weeks of the year and a limited dataset, so it may be a little premature to call that a trend. If it becomes one, that will be something of a reversal given that issuance in the high-yield market has been migrating to its higher rungs in recent years, as the investment-grade market has become more concentrated in its lower tiers. In fact, that investment-grade trend triggered plenty of anxiety as valuations became increasingly tight in 2018 and 2019, leaving less room for error in BBB debt pricing. Therefore, it wasn't surprising when the early-2020 coronavirus-driven sell-off pummeled BBB bonds nearly twice as hard as it did AAA rated corporates.

The entire universe of junk bonds is orders of magnitude smaller than the pool of BBB rated corporate debt alone, so borrowing trends in leveraged businesses can sometimes trigger fundamental shifts in the market's makeup, particularly at the sector level. That happened after passage of the Telecommunications Act of 1996 led to a proliferation of smaller carriers looking to compete with large incumbent phone companies that still dominated telephony. Those startups found plenty of hospitality on Wall Street as bankers found it easy to sell debt while falling yields were driving investor dollars into a high-yield market enjoying double-digit growth.

That mix of circumstances made most high-yield bond managers nervous. Their own businesses were booming, but that meant they had to put investor money into a market that was heating up and being flooded with progressively riskier telecom deals. Even among the most intrepid of those managers, it would have been difficult to justify stuffing as much into their portfolios as the market was selling. Those that resisted the hardest wound up serving their shareholders well. The borrowing binge fundamentally changed the junk-bond landscape, and by mid-2000 the telecom sector had ballooned to constitute more than 20% of the high-yield market. The pain that followed was gut-wrenching as the sector plummeted by nearly 40% over the next two years.

That's an extreme example, but the market has binged on other sectors over the years. The 2008 global financial crisis took some froth out of sky-high oil prices when they plummeted below $60 per barrel during the crisis, but oil snapped back hard and floated above $100 per barrel over the next few years. That drove massive investment in an oil sector giddy over advances in drilling technology, and by late 2014 the energy sector made up roughly 16% of the high-yield market. Just as that drilling began to really pay off, though, oil prices plummeted and haven't returned anywhere close to those heights. Once again, bond investors paid a hefty price for the market's binge. Between late 2014 and early 2016, a period comprising two nasty stretches of upheaval in commodities markets overall, high-yield energy debt endured losses of roughly 30%.

Fund managers aren't immune to excesses in the bond market, though the more experienced and skilled among them can usually see trouble coming, especially when it arrives in the form of investment bankers itching to sell heaps of bonds from highly leveraged companies in the same sectors. It can be extremely difficult to stray too far from a market against whose indexes they will ultimately be compared given that trying to get out of the way early can make for long stretches of unflattering comparisons. Disciplined managers also understand, however, that putting 15% or 20% in a single high-yield sector may have the potential to bury them if those industries are routed.

The case for sticking with active high-yield managers over indexed portfolios isn't entirely open and shut given that there are always active funds that manage to find trouble when it comes their way, and an extremely cheap index fund can look very competitive depending on the period and vagaries of the investing landscape. The high-yield market is among those best suited to reward deep research for a variety of reasons, though, and most active managers and firms favored by Morningstar analysts are reluctant to follow credit markets all the way to extremes, regardless of how committed they are to benchmarking. There's plenty of room for indexed portfolios among higher-quality parts of the bond market, but it's worth thinking twice before following it when it comes to buying high-yield bond funds.