Dangerous (?) Curve Ahead: Inverted Yield Curves and High Yield Bond Performance
In May, the yield spread between 3-month U.S. Treasury Bills and 10-year U.S. Treasury Notes turned negative; in other words, the yield curve inverted. Historically, this phenomenon has proven to be a useful leading indicator of a recession. However, while it is true that the yield curve has inverted prior to each U.S. recession dating back to the 1960s, without producing a false signal, there appears to be little to no information embedded in this signal as to the timing of the recession that follows. Admittedly, this missing information is a very important piece.
Be that as it may, if we assume that the indicator will once again correctly predict a coming recession, we thought that it would be worthwhile to examine how the high yield market has historically reacted to this event and whether there is a useful pattern to be uncovered as it relates to such market’s overall performance.
Before we go any further, however, it is worth discussing the genesis of the belief that an inverted yield curve foreshadows a recession. This idea was first introduced in the mid-1980s by a PhD student named Campbell Harvey, who observed that the yield curve had inverted prior to each recession between 1960 and 1980.1 Typically, the yield curve is upward sloping (i.e., yields increase as the term to maturity increases as investors demand more yield in exchange for lending money for longer periods). However, during periods of inversion, the curve slopes downward; specifically, the spread between the shorter-dated 3-month UST-Bill and the longer-dated 10-year UST-Note becomes negative.
Today, it is widely accepted that as risk aversion increases, investors engage in a flight to quality. As a result, the price of the 10-year UST-Note, generally viewed as the safest place to hide out during times of trouble, increases while its yield correspondingly declines. To the extent that this increased demand for the 10-year UST-Note ultimately pushes its yield below that of 3-month UST-Bill, the yield curve is said to have inverted.2 Since the formation of the modern high yield market, there have been three periods of similar inversion, coinciding with three subsequent recessions. Below is a table (Exhibit 1) detailing the pertinent dates representing these periods.
For three of these periods, we show the inversion period; the length of inversion; the ensuing recession time frame; and the length of time from when the yield curve first inverted to the beginning of the ensuing recession. Earlier, we mentioned that while an inverted yield curve has served as a good leading indicator for a recession, the inversion itself does not provide much information on when the recession will begin. From the table above, one can see that the inversion period ended seven months before the 2007 recession (“Great Financial Crisis”); six months before the 1990 recession; and only two months prior to the 2001 recession. However, a leading indicator of recession does not need to provide a precise prediction to nevertheless still be useful.
With that in mind, let us turn our attention to the high yield market and how it has historically performed during these periods of yield curve inversion. Specifically, we wanted to observe the performance of the high yield market in the time periods both leading up to the inversion and following the inversion, as well as for the entire period. Given that an inversion is believed to result from growing concerns of market participants about risk, one would expect the high yield market to produce below-coupon returns during such period (i.e., bond prices would decline).
The table below (Exhibit 2) details how the high yield market performed for both the one-year period prior to the inversion and the subsequent year after the inversion as well as the full two-year period. From the data, we note that Price Returns were generally negative. Total Returns, on the contrary, are evenly mixed between positive and negative results, which highlights the positive effect that coupon payments have on Total Returns. This data suggests that as the yield curve inverts, and risk aversion in the market increases, the price of high yield bonds will decline. This last point seems intuitive; after all, high yield bonds are highly sensitive to changes in economic activity, and if the shape of the yield curve signals an impending slowdown, one would expect the high yield market to generate sub-coupon returns as prices experience some degree of depreciation in a risk-off environment.
With that in mind, we analyzed the data from historical periods of yield curve inversion in an effort to perhaps shed some light on current circumstances in the market. In particular, we were curious whether some of the anomalies occurring in the high yield market in 2019 could be a reaction to the inverted yield curve. One such anomaly in today’s market was highlighted by Deutsche Bank in a recently published piece. The authors stated that year-to-date BB-rated bonds have significantly outperformed bonds rated CCC, but, for the first time ever, are doing so when the broader high yield market is generating a double digit return.3 In addition, the market produced another first in August, when the option adjusted spread (OAS) for BB/B-rated bonds fell below 350 basis points while bonds rated CCC and below had an OAS exceeding 1,000 basis points.4 Of course, these two anomalies are somewhat related to each other, as the spread dispersion among the ratings tiers is, at least in part, responsible for the return dispersion between such tiers. That being said, is the inverted yield curve otherwise correlated with the occurrence of these anomalies in the high yield market today?
Accordingly, we focused on the following question “has it always been the case that BB-rated bonds have outperformed bonds rated CCC and below during periods marked with an inverted yield curve?” Said another way, “historically, has there been a flight to quality in the high yield market specifically in connection with the broader flight to quality ahead of a recession?” The table below (Exhibit 3) details the performance differential between BB-rated bonds and bonds rated CCC and below for three distinct periods, namely Periods 2, 3 and 4 as defined in Exhibit 1. (For Period 4, for this purpose, we are assuming that today’s inverted yield curve has foreshadowed a recession).
Unfortunately, the data does not provide us with a clear answer. While Period 2 and the more recent Period 4 both show BB-rated bonds performance far exceeding the returns of bonds rated CCC and below, Period 3 shows the opposite. Certainly, each period covered has unique circumstances that influenced performance beyond the impact of an inverted yield curve. For example, during Period 3 (i.e., the Great Financial Crisis), the inversion occurred during the peak of real estate prices in the U.S. at a time when there was limited concern about the prospects for continuing economic growth. In fact, during that time frame, the Fed was still hiking interest rates. Contrast that with Periods 2 and 4, where in each case the Fed had stopped hiking rates and the 10-year UST-Note yield declined at a faster rate than yield on the 3-month UST-Bill, which might help explain why those two periods produced similar results with respect to the performance returns of BB-rated bonds as compared with bonds rated CCC and below.
Therefore, we must ask ourselves which environment is the most akin to today’s, the early- or the mid- 2000s? Are we at the precipice of a recession, or is a downturn still further out on the horizon? It is difficult for us to say with any certainty, but at least in the United States, the economy continues to grow, the unemployment rate remains low, and consumer confidence is still relatively high. Perhaps these factors, coupled with a favorable resolution of other macroeconomic issues (such as the brimming trade war between the United States and China), will be enough to reverse some of the weakness experienced among lower-rated issuers during the past year. Alternatively, the weakness in the lower tier of the high yield market that we are seeing today could be the proverbial canary in the coal mine, foreshadowing the sooner onset of a broader economic pullback.
Finally, there have been eight recessions since the 1960s and although each was preceded by an inverted yield curve, this data set is a relatively small sample size. Additionally, only three of those recessions have occurred since the inception of the modern high yield market in the mid-1980s. As a result, attempting to draw meaningful conclusions related to the high yield market from such a small sample is admittedly a challenging exercise.
Moreover, it is difficult for one to discern whether the yield curve is responding to the business cycle or the business cycle is responding to the yield curve. Along these lines, while the yield curve has inverted prior to the start of each recession since the 1960s, it has also normalized in almost every case before such recession began. Accordingly, it is difficult for us to draw any firm conclusions from an inverted yield curve as it relates to the precise timing of the next recession; whether it arrives two months from now or two years from now is a question for which we do not have the answer.
That being said, the adage “history doesn’t repeat itself, but it often rhymes” is worth bearing in mind. While the timing of the next recession remains uncertain, the business cycle dictates that it will arrive at some point, and an inverted yield curve has been a reliable indicator that one is on the way. However, regardless of the timing of the onset of the next recession, what we do know is that over the long-term, history has shown that the high yield market has returned its coupon with only minimal effect from price changes. Therefore, we believe that investors, rather than attempting to time the market based on any kind of signal associated with a yield curve inversion, should instead maintain a strategic allocation to high yield, and similarly remain disciplined during periods of heightened market volatility that are likely to precede the inevitable coming recession. In our view, this approach, which captures the benefit of compounding the coupon income generated by an investment in the high yield market, will potentially maximize an investor’s total returns in the asset class over the long term.
1 Campbell R. Harvey is presently a Professor of Finance at the Fuqua School of Business, Duke University, and a Research Associate of the National Bureau of Economic Research in Cambridge, Massachusetts.
2 Interview with Professor Harvey from July 2019 discussing the latest inversion and his original thesis. https:/today.duke. edu/2019/07/its-official-yield-curve-triggered-does-recession-loom-horizon
3 Deutsche Bank Research: “BBs Outperforming CCCs…In a Double- Digit Return Year?” Craig Nicol and Nick Burns, September 6, 2019.
4 S&P Leveraged Commentary and Data: “What to make of present CCC-C undervaluation?” Marty Fridson, August 27, 2019.
High Yield Bond: A high yield bond is a debt security issued by a corporate entity where the debt has lower than investment grade ratings. It is a major component – along with leveraged loans – of the leveraged credit market.
Investment Grade: Investment grade are those securities rated Baa3/BBB-/BBB- or above by Moody’s, S&P, and/or Fitch, respectively.
Price Return: Measures the price appreciation or percentage change in price of a security or the securities in an index or portfolio, thus excluding impact of interest and coupon payments.
Total Return: Total return, when measuring performance, is the actual rate of return of an investment over a given evaluation period. Total return includes interest and coupon payments realized over a given period of time.
Spread: The yield of a bond minus the yield of the government bond that matches the maturity (or appropriate call date) of the bond.
Yield: The yield is the income return on an investment, such as the interest or dividends received from holding a particular security.
Yield Curve: A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. There are three main types of yield curve shapes: normal (upward sloping curve), inverted (downward sloping curve) and flat.
Yield Spread: A yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings and risk, calculated by deducting the yield of one instrument from another.
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