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On April 9th, the U.S. Federal Reserve announced a dramatic expansion of its lending program with plans to inject as much as $2.3 trillion into the economy. Included in the mix were selected high yield bonds.
Some of this was a reaction to the fundamentals – the economy has slowed dramatically and corporate bonds have sold off on concerns about credit quality – but it also reflects worries over the impact that a sudden loss of liquidity has had on the market.
Markets need liquidity – a more or less equal match in interest between buyers and sellers – to function smoothly. But in a crisis, liquidity often evaporates as fundamental values are pushed aside in the rush for the exits. As buyers disappear, efficient price discovery vanishes. Experience has shown that with time, liquidity, returns and prices generally recover to better reflect the fundamental value of the underlying assets, but we are obviously in uncharted waters right now and it’s effectively anyone’s guess as to when things might return to anything like normal. So the Fed’s decision to buy bonds, and to extend its program to segments of the high yield end of the market, is designed to address those liquidity issues, providing a bridge to the point when markets can function normally on their own.
The unprecedented move clearly had an impact. Following the Fed action, high yield spreads relative to treasuries tightened dramatically and high yield bond prices jumped. This seemed to confirm that at least part of the market decline was liquidity driven. In the final analysis, the market will have its say and lower rated credits are likely to struggle as the economy stays on its coronavirus-driven lockdown. But, again, a lesson from past crises is that asset prices have tended to recover over time, rewarding patience on the part of investors.
Elevated levels of volatility can make it hard to be patient, however. In high yield as elsewhere, diversification can help investors weather this period of uncertainty. An ETF built on an underlying methodology that includes a broad portfolio of lower volatility, high yield bonds diversified by sector is one approach. IQ S&P High Yield Low Volatility Bond ETF (HYLV) Besides the potential for a recovery in asset prices, there are other benefits to staying the course. A non-intuitive one is the impact on dividend reinvestment.
As prices decline, reinvested dividends allow an investor to expand a position at lower cost, a kind of automated dollar cost averaging. At the same time, the decline in asset prices often means that the effective yield of a fund goes up, so that new money generates a higher level of income (which can itself be reinvested). Because bond funds and ETFs pay dividends on a monthly basis, the impact of this reinvestment strategy can be seen quickly.
In times of crisis, money tends to gravitate towards U.S. Treasuries and other safe havens, and away from credit assets like high yield bonds. Some of this is rational; some driven by fear. Even the most committed efficient market theorist would have to admit that there are times when markets behave in inefficient ways. It seems to us that we are in the midst of one of those periods. By its actions, the Fed seems to think so, too. While its decision to step into the high yield market for the first time ever is an important one, we are not out of the woods yet. Investors should take notice of the Fed’s action and give thought to the various ways high yield exposure has been and can continue to be included in an overall fixed income portfolio. One of those ways may be to consider investing in lower volatility high yield bonds.
Related: Investors Are Confronted With Two Major Decisions in Times Like These