At Zeo, we’ve often been asked how our investment approach can mitigate volatility when investing in high yield bonds. Of course, one of the ways we proceed in our short-term income strategy is to carefully control the duration of the portfolio. But even in our unrestricted term credit strategy, where we have the option of taking additional term, the portfolio has shown a knack for being relatively boring, and we say so with pride. We have always maintained that, in addition to duration, it is our fundamental analysis that has a significant impact on underlying risk and portfolio volatility. We started to approach this in terms of approach in the previous section, but we can also put some numbers behind this claim.
For the next discussion, we’ll ask readers to set aside the impact of the duration reduction by focusing only on the larger high yield market. Reducing the duration would only dampen volatility further, but we wanted to isolate the impact of our stock selection only. One of the results of our careful attention to issuers, business models and sustainability is that we find that some industries are rarely found in our portfolio and others that are regularly represented. Because we manage our portfolio with the goal of generating attractive risk-adjusted returns, we tend not to favor sectors that contribute disproportionately to high yield market volatility. In this letter, we have decided to show that this is the case and to help our readers understand the consequences of this result.
Our analysis was performed using data from Bloomberg Finance LP, analyzed by their own analyzes on their own Bloomberg Barclays US Corporate High Yield Index over the past three years. These three years were marked by a decline in the market (end of 2018), a significant rally (end of 2019), a dislocation of the market (beginning of 2020) and a continuous recovery and rally to new historic highs (end of 2020 until now) (see Figure 1). From start to finish, the high yield market is at an all-time high, with credit spreads and interest rates flirting with all-time lows, again, as illustrated in the chart below.
Exhibit A in the appendix to this letter contains a table that shows the standard deviation of the index, as well as the standard deviations of each sector of the index during the same period. We sorted the sectors by standard deviation (largest to smallest), separating those with higher volatility than the index in the left column and those with lower volatility than the index in the column. of right.
We can quickly see which sectors are contributing the most to high yield market volatility. Some will not be a surprise. We have long shared our view that the price of oil, for example, is a reasonable indicator for the high yield market, and the material impact of the energy sector is highlighted in Figure 2, as “Energy – Integrated”, “Energy – Independent” and “Oil Field Services” are the three most volatile sectors in the High Yield Index.
What may be more surprising, however, can be found in Exhibit B in the appendix. When we compare the annualized performance over these three years of sectors with higher than average volatility to sectors with lower than average volatility, we get a counterintuitive result. Sectors with lower volatility in fact outperformed the sectors with the highest volatility, and this during a high yield bull market! In addition, these sectors represent less than 40% of the index.
The implications of these observations are important. Ultimately, mitigating volatility may not have a significant detrimental effect on performance over time, if at all. In addition, it may not be necessary to analyze the entire high yield in order to identify a portfolio that may outperform the index if one knows how to narrow the universe to reasonable investment candidates. Indeed, we have long believed that not trying to ‘boil the ocean’ with representation from each sector can provide a more consistent and attractive risk profile.
An important caveat here is that Zeo does not rotate between industries based on economic perspectives. We don’t decide to invest in sectors first and companies second. We invest first and always in companies. Therefore, as readers who have followed our portfolio for a long time will recognize, our sector representation tends to be fairly consistent. Even so, it also tends to be fairly low volatility. Tables C and D of the appendix show the concentration of our portfolio in each sector of appendix A. What these tables show is that, whatever our mandate of duration, our fundamental research naturally privileges the sectors. which have standard deviations below the mean.
Unfortunately for readers who have already started considering starting a high yield bond fund by simply filtering out high volatility sectors, that’s not all. There is always a significant amount of risk in a large filtered market portfolio with unmanaged duration, and there is a lot of work to be done in stock picking to separate the wheat from the chaff. But an approach that aims to mitigate volatility and generate strong risk-adjusted returns doesn’t necessarily compromise performance over unmanaged indices. Even so, it can potentially provide a risk profile which could be more appropriately termed HYINO – High Yield In Name Only.
As much as anything we have shared in this letter, at Zeo we deeply believe that our clients do better if we stay true to our core philosophies: to be consistent, transparent and intentional. Many of you have been reading our writings for some time now. We have discussed the dynamics of our strategies over the years. We have been open about what scenarios our approach might outperform and when we should expect it to be “good enough” that we can expect the environment in which our strategies can shine. We believe that the current environment, now and for the next few years, is this.
Important Disclosure Information
Zeo Capital Advisors is a fundamental investment manager for short term credit mutual fund, high yield sustainable mutual fund and separately managed accounts. Venk is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
For more information, contact Zeo directly at 415-875-5604 or visit www.zeo.com.
Remember that past performance may not be indicative of future results. Different types of investment involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy or product (including investments and / or investment strategies recommended or undertaken by Zeo Capital Advisors, LLC (“Zeo”)), or any content unrelated to the investment referred to directly or indirectly in this newsletter will be profitable, equal to any corresponding historical performance level indicated, will be appropriate to your portfolio or individual circumstances, or prove to be successful. Due to various factors, including changing market conditions and / or applicable laws, the content may no longer reflect current opinions or positions. furthermore, you should not assume that any discussion or information contained in this newsletter serves as a receipt or substitute for personalized investment advice from Z eo. To the extent that a reader has questions regarding the applicability of a specific problem discussed above to their individual situation, they are encouraged to consult the professional advisor of their choice. Zeo is neither a law firm nor a chartered accountancy firm, and no part of the newsletter content should be construed as legal or accounting advice. A copy of Zeo’s current written disclosure brochure covering our advisory services and fees is available on request or at www.zeo.com/disclosures.