Prior to the Global Financial Crisis, yield had been low and suppressed for quite some time following the Dot-Com Crisis. With yields low and markets benign during the middle part of the 2000s, many investors dialed up their risk exposure to chase after yield. When markets reversed, they paid the price.
During the Global Financial Crisis, these spread asset classes typically lost between 15% and 25% of their value, shown below.
Source: Source: Zephyr StyleADVISOR
Based on these numbers, these types of bonds should be viewed as a “risk” asset, not a “protection” asset. Those chasing yield in High Yield Bonds would have suffered losses in the neighborhood of 24.25% during the crisis.
Another subtler but perhaps even more worrisome point to note is regarding investment grade bonds. The two columns on the far right display the Morningstar category average for Intermediate Term Bonds and the Barclays U.S. Aggregate Bond Index, respectively. In theory, both are meant to represent safe, investment grade bonds.
However, the performance gap between the two is quite large—over 12%. During the Global Financial Crisis the Barclays Aggregate Index was indeed up 9.17%, offsetting equity losses if used in a balanced portfolio. However, the average Intermediate Term Bond fund fared much worse during this period, losing over 3%. it is fair to assume a lot of active managers went chasing after yield, even though their mandate might have been investment grade bonds.
Barron’s recently ran a thorough and worrying article called “Where the Bond Market’s Next Big Problem Could Start” by Vito Racanelli. The author explores the large “bulge” of corporate debt sitting right on the investment grade/speculative grade cusp and wonders what might happen if this BBB-rated debt tips over into BB-range. For those looking for icebergs on the horizon, it is a good read.
How will such assets fare in another downturn when spreads have been squeezed to razor-thin margins? Time will tell, but the forecast is not favorable.