At Zeo, we have often been asked how our investment approach can mitigate volatility when we invest in high yield bonds. Of course, one way in which we do so in our Short Duration Income Strategy is by carefully controlling the portfolio duration. But even in our Duration Unconstrained Credit Strategy, where we have the flexibility to take on additional duration, the portfolio has shown a knack for being relatively boring, and we say that with pride. We have always made the case that, aside from duration, it is our fundamental analysis which has a significant impact on the underlying risk and volatility of the portfolio.
For the following discussion, we will ask readers to set aside the impact of lowering duration by focusing on only the broader high yield market. Lowering duration would only further mitigate volatility, but we wanted to isolate the impact of just our security selection. One of the outcomes of our careful focus on issuers, business models and sustainability is that we find there are certain industries which rarely find their way into our portfolio and others which are regularly represented. Because we manage our portfolio with a goal of delivering attractive risk-adjusted returns, we tend not to favor those sectors which contribute disproportionately to high yield market volatility. In this letter, we decided to show that this is the case and help our readers understand the consequences of this outcome.
Our analysis was done using data from Bloomberg Finance LP run through their own analytics on their own Bloomberg Barclays US Corporate High Yield Index over the last three years. Those three years contained a market decline (late 2018), a significant rally (late 2019), a market dislocation (early 2020) and a recovery and continued rally to new all-time highs (late 2020 until now) (see Figure 1). Start to finish, the high yield market is at its highest levels, with credit spreads and interest rates flirting with all-time lows, again, as illustrated in Figure 1.
Figure 1: High yield total return and high yield spread represent the Bloomberg Barclays US Corporate High Yield Index. Data source: Bloomberg Finance LP.
Exhibit A in the Appendix contains a table which shows the standard deviation of the index, as well as the standard deviations of each sector in the index in the same period. We have sorted the sectors by standard deviation (greatest to smallest), separating those which had greater volatility than the index into the left column and those which had lower volatility than the index into the right column.
We can quickly see which sectors contribute most to the volatility of the high yield market. Some will not come as 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 evidenced in Figure 2, as “Energy – Integrated”, “Energy – Independent” and “Oil Field Services” are the three most volatile sectors in the high yield index.
Figure 2: Represents the three most volatile sectors in the Bloomberg Barclays US Corporate High Yield Bond Index based on three-year standard deviation. See the Appendix for the full table.
What may come as more of a surprise, however, can be found in Exhibit B in the Appendix. When we compare the annualized performance over these three years of the sectors with above average volatility to the sectors with below average volatility, we get a counterintuitive result. The lower volatility sectors actually outperformed the higher volatility sectors, and this during a bull market for high yield! Furthermore, those sectors make up less than 40% of the index.
The implications of these observations are significant. As it turns out, mitigating volatility may not have a materially detrimental effect on performance over time, if at all. In addition, it may not be necessary to analyze all of high yield in order to identify a portfolio which can outperform the index if one knows how to narrow the universe to reasonable investment candidates. Indeed, we’ve long held that not trying to “boil the ocean” with representation from every sector can deliver a more consistent and attractive risk profile.
One important caveat here is that Zeo does not rotate between sectors based on economic views. We are not deciding to invest in sectors first and companies second. We invest in companies first and always. As a result, as readers who have watched 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. Exhibit C and D in the Appendix show the concentration of our portfolio in each sector found in Exhibit A. What these tables show is that, regardless of our duration mandate, our fundamental research naturally prefers those sectors which have below average standard deviations.
Unfortunately for those readers who have already started looking into launching a high yield bond fund by just filtering out high volatility sectors, this is not the full story. There is still a significant amount of risk in a filtered broad market portfolio with unmanaged duration, and there is a lot of work which must go into security selection to separate the wheat from the chaff. But an approach which aims to mitigate volatility and deliver strong risk-adjusted returns is not necessarily making a performance trade-off relative to unmanaged indices. Even so, it can potentially deliver a risk profile which might be most appropriately labeled a HYINO – High Yield In Name Only.
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We at Zeo believe to our core that our clients are better off if we remain true to our foundational firm philosophies: to be consistent, transparent and intentional. Many of you have been reading our writing for some time now. We have discussed throughout the years the dynamics of our strategies. We have been forthcoming about the scenarios in which our approach may outperform and when one should expect it to be “good enough” so that we may lie in wait for the environment in which our strategies can shine. We believe the current environment, now and looking forward for the next several years, is that time.
APPENDIX
Exhibit A
Broad Market High Yield 3-Year Standard Deviations By Sector
Exhibit A: 3-year standard deviation by sector in high yield market based on Bloomberg Barclays US Corporate High Yield Bond Index from 6/29/2018 to 6/30/2021. (Source: Bloomberg Finance L.P.)
Exhibit B
Exhibit B: Overall and filtered statistics represent aggregated data based on actual weightings and performance for the same period.
Exhibit C
Zeo Short Duration Income By Sector (as of 6/30/2021)
Exhibit C: Current portfolio breakdown of Zeo Short Duration Income Strategy by sector, grouped by broad market high yield 3-year standard deviations (Sources: Zeo Capital Advisors, Bloomberg Finance L.P.) [Note: Portfolio data taken from largest account managed according to the strategy.]
Exhibit D
Zeo Duration Unconstrained Credit By Sector (as of 6/30/2021)
Exhibit D: Current portfolio breakdown of Zeo Duration Unconstrained Credit Strategy by sector, grouped by broad market high yield 3-year standard deviations (Sources: Zeo Capital Advisors, Bloomberg Finance L.P.) [Note: Portfolio data taken from largest account managed according to the strategy.]
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By Venk Reddy
Originally published in Q2 2021 letter
Important Disclosure Information
Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and 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.
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