Fridson: High-yield returns before and during recessions

This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC as well as a contributing analyst to Leveraged Commentary & Data.

This piece recommends pre-recession and recession strategies for allocation among fixed-income categories and among high-yield sectors. The conclusion addresses timing for instituting and terminating those strategies.

Present motivation

After two intraday inversions, the 2-to-10 Treasury curve closed in an inverted state on April 1 and April 4. During the next four days the curve reverted to a positive slope, closing out the week at +19 bps. That did not, however, end the market chatter about the possibility of recession ahead.

Investors can consult many other sources about the controversies surrounding the inversion. For example, pundits are debating whether the two-year is the correct proxy for the short end or whether the three-month Treasury bill is more appropriate. In addition, some strategists contend that a yield curve inversion in the current market is not comparable with past inversions due to the impact of the Fed's quantitative easing on the long end.

Not in the question is the documented fact that recessions, as declared by the National Bureau of Economic Research (NBER), do not commence immediately after the yield curve inverts. For instance, based on month-end data, the 2-to-10 curve inverted in February 2000. The next recession did not begin until 14 months later, in April 2001. (There was an ever greater lag to that recession from an inversion that occurred in June 1998.)

Economist David Rosenberg cautions against trying to pick up nickels in front of a steamroller, a classic metaphor for attempting to capture the last small gains before the market plunges. Bond managers do not, however, have the option of going to 100% cash at the first whiff of recession. Their clients or fund shareholders require them to stay invested and do the best they can within their assigned market categories. To fulfill that charge as successfully as possible, it is worthwhile to seek guidance (not necessarily to be followed robotically) from the historical returns in the lead-ups to, as well as during actual, recessions.

Historical returns available from ICE Indices, LLC enable us to examine four past recessions. We address the asset allocation questions faced by both general fixed-income managers and high-yield specialists. This represents quite a small sample for study, yet some useful observations emerge from the analysis. Let us focus first on the more straightforward findings about the recessionary phase of the business cycle.

Checking the record on comparative returns in recessions

The table below displays returns for four core fixed-income categories during the last four NBER-defined recessions, with each recession's best performer shaded. Bear in mind that fixed-income portfolio managers will not know exactly when the next recession is beginning. Only months after the fact does the NBER determine when the economy officially went into recession.

As far as fixed-income allocation goes, the findings are clear-cut. High-yield is the only one of the four fixed-income categories that was not the best performer in at least one recession. In fact, a line-by-line examination reveals that high-yield was the worst performer every single time. These results are no great surprise, considering that defaults rise during recessions. Default risk is greatest in the high-yield market, making it a category to flee from rather than flee to during a recession.

Digging deeper, we find that the high-yield total return was negative in three recessions, while only one of the three other categories recorded even one negative return. Our findings do not make a case for expecting one particular fixed-income category to be the next recession's best performer. It seems pretty clear, however, that multi-category bond managers should underweight high-yield bonds when they believe the economy is in recession. A final observation on this table is that the mortgage-backed market, widely regarded as the villain in the Global Financial Crisis that triggered the Great Recession of 2008-2009, was that recession's best fixed-income performer.

Pivoting to MBS or Treasury bonds is not an option for managers of high-yield mutual funds or institutional high-yield mandates. The table below addresses two of the key top-down tools at their command — rating and maturity. Note that the requisite breakdowns of the ICE BofA US High Yield Index are available only for the three most recent recessions. As in the preceding table, the findings are consistent with intuition.

In all four recessions, BB was the best-performing rating category and CCC & Lower was the worst. That is what most readers would have guessed, based on experience or on theory alone. Defaults rise in and around recessions, so investors flee the issues with greatest proximity to default for the relative safety of those most remote from default.

The findings on maturity are a bit more complex in conceptual terms. As one would expect, Treasury rates fell sharply in all three recessions. One might further suppose that a declining-rate environment would favor the longest-dated, i.e., most rate-sensitive, Treasurys. That would in turn imply that longer-dated high-yield bonds (represented by the 7-10 year basket) would receive greater support from underlying Treasurys than shorter-dated high-yield issues (represented by the 3-5 year basket).

What actually happened was that the Treasury curve between 5 and 10 years steepened in all three recessions. In the 2000-2001 and 2008-2009 recessions the steepening of 42 and 38 bps, respectively, translated into higher returns on 5-year Treasuries than on 10-year Treasuries. That pattern was mirrored in superior performance by the 3-5 year high-yield maturity basket.

Portfolio managers should perhaps give less weight to the highly unusual (shortest on record and pandemic-triggered) 2020 recession, but in that case the 5-10 year steepening measured just 6 bps. The 10-year Treasury posted a substantially higher total return than the 5-year Treasury. Once again, the high-yield market followed suit, as the 7-10 basket outperformed the 3-5 basket.

It is not clear from the historical evidence which recession(s) represent the best precedent for portfolio managers who will face the maturity decision when the next recession commences. They are better advised to leave their maturity distributions undisturbed and focus on their ratings mix plus two tools not addressed in this piece, industry allocation and individual security selection.

History suggests that a recession, if it is to follow the recent 2-10 inversion, will follow it only with a substantial lag. As of April 2022, therefore, portfolio managers' more pressing concern is how fixed-income categories and high-yield sectors perform in advance of recessions. The following table addresses the asset class question with 12 months as the chosen lead-up period.

As with the recession returns by asset class, the pre-recession results are no surprise. High-yield was the worst-performing fixed-income category in the lead-ups to all four recessions. Evidently anticipating the recessions and the associated rises in default rates, investors fled the default-prone high-yield market in favor of investment-grade bonds. Once again, none of the other three fixed-income categories captured top-performer honors in all instances. 

Finally, we turn to pre-recession returns by the high-yield sector. The table below shows, consistent with intuition, that CCC & Lower bonds, i.e., those most proximate to default, consistently performed worst in the lead-ups to recessions. In advance of the 2008-2009 recession, the BB and B categories took almost exactly equivalent price hits, but the B category's higher income enabled it to beat BBs' total return. We conclude that the best sector strategy for the pre-recession period is to reduce CCC & Lower exposure without betting on whether BBs will perform better or worse than Bs.

As in the preceding analysis of recession returns, the pre-recession returns by maturity do not point unambiguously to an optimal strategy. The longer-maturity issues delivered a higher total return than the shorter-maturity issues in the two most recent lead-ups to recessions, but the opposite occurred in the 2001 recession. All three recessions were characterized by yield curve steepening between 5 and 10 years, but in the 12 months prior to the 2008-2009 recession, the 7-10 year high-yield basket outperformed the 3-5 year basket even though the 5-year Treasury outperformed the 10-year Treasury. With no clear-cut pattern to rely on, portfolio managers should focus on underweighting BBs in the pre-recessionary period while striving for additional alpha through industry allocation and security selection, rather than duration management.

 

Conclusion

As mentioned near the beginning of this piece, portfolio managers cannot be certain when a recession begins, as that is not decided by the NBER until months after the fact. It would be even more difficult to know exactly when the start of the next recession is precisely 12 months in the future. Portfolio managers must recognize these limitations when determining how to apply this piece's findings on asset class and high-yield sector returns.

We recommend treating the pre-recession and recession periods as a whole, given that the recommended strategies for the two subperiods are similar. As soon as an investment organization comes to believe that the economy is headed toward recession, perhaps based in part by a Treasury curve inversion, its bond managers should reduce high-yield exposure and its high-yield managers should reduce CCC & Lower exposure. Those strategies should remain in place until the monthly high-yield return turns positive. That happened in December 2008 and from that point through the end of the recession, high-yield dramatically outperformed the other fixed-income classes and CCC & Lower bonds decisively beat the BB and B total returns.

To determine whether further alpha can be generated in high-yield portfolios through industry selection, we will follow up this piece with a similar analysis of industry returns during combined pre-recession/recession periods.

Research assistance by Tinglan Li and Christopher Robinson.

ICE BofA Index System data is used by permission. Copyright © 2022 ICE Data Services. The use of the above in no way implies that ICE Data Services or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Lehmann Livian Fridson Advisors LLC's use of such information. The information is provided "as is" and none of ICE Data Services or any of its affiliates warrants the accuracy or completeness of the information.

Featured image by Shutterstock