EXPANDING INVESTMENT HORIZONS OF ULTRA-CONSERVATIVE INVESTORS
The QAS S-128 Global High-Yield with Max Protection Strategy Index mentioned in this article is currently licensed to U.S. and U.K.*asset management companies.
There are certain areas of financial markets that are considered “high-risk”, and carry a stereotyped cliché (stamped by academia) of being “not-welcomed” into a portfolio of a conservative investor. The Junk Bond Market (High-Yield) is one of them.
Let’s have a closer look at the high-yield investment and review two graphs for iShares iBoxx $ U.S. High-Yield Corporate Bond ETF (HYG).
As you can see on the graph below, HYG’s price looks extremely unattractive with a 10-Yr CAGR% of -2.0%.
The risk profile of this investment instrument is typically explained by two components – (1) “high volatility” and (2) “low quality or default risk” associated with “junk bonds” credit ratings (BB and below) which are also called “non-investment grade” bonds. Both are correct, and in conjunction with a miserable price performance of -2% (10-Yr CAGR%), makes this investment considerably less attractive than such investments as U.S. Large Cap stocks and U.S. Investment Grade bonds.
However, in reality this analysis can be misleading if we don’t take into consideration another very important aspect of this investment – “YIELD”. Junk bonds (High-Yield Bonds) carry much higher yield levels when compared to other “sleeves” of the fixed income universe due to their higher risk profile.
It is interesting that during the market meltdown of 07-09, the yields for junk bonds skyrocketed. During that period, the yield to maturity (YTM) for speculative-grade bonds in the U.S. market rose more than 20%. As a result, HYG ETF (as our example) returned a spectacular +60% in 2009, outperforming all equity indexes (S&P 500 +23.5%). However, such massive yearly returns do not occur very often, and even with inclusion of yield distribution HYG ETF returned only +6% 10-Yr CAGR%.
In our second graph we added the total return (TR) historical price of HYG ETF that includes a yield-based distribution. You can see the difference in price levels “with” and “without” yield input. Therefore, the key in the understanding of any fixed income investment is the “total return” price analysis.
However, even with yield input taken into consideration, the “equity-like” drawdowns pattern (5-40% range) in conjunction with the structural “default” risk parameter requires “special” attention when investing in “junk” bonds, especially true for an ultra-conservative investor, who desires a consistently reliable low investment risk profile, and accepts returns slightly higher (if possible) than the risk-free rate. Therefore, according to traditional risk profiling methods, this type of investor (or his financial advisor) should not be considering “junk” bonds, especially beyond U.S. geography (EU, EM etc) where risk profiles are typically even higher.
The QAS S-128 Global High-Yield with Maximum Protection Strategy is a new solution for the “ultra-conservative” investor.
We set an ambitious goal when we decided to expand traditional horizons of the “ultra-conservative” investor and include global “junk” bonds (US, EU and EM) into the mix. We like the fact that “high-yield” instruments around the world periodically present serious investment opportunities. At the same time, we understand that we have to reduce the maximum drawdown from upward of 40% levels to 5% or less.
Our global “high-yield” basket includes the following ETFs. As you can see, all three instruments offer significant yield levels.
Source: iShares ETFs as of 09/06/2018
The QAS tool-box allowed us to construct a 3-Regime allocation scheme for an ETF-based model portfolio that does the following:
Regime 1 >> Aggressive [100% Global High-Yield Exposure].
Regime 2 >> Neutral [75% Global High-Yield Exposure].
Regime 3 >> Defensive [0% Global High-Yield Exposure].
The multi-regime structure allows us to implement a gradual risk management procedure, where we reduce the overall global high-yield bond exposure down to 75% and further down to 0%, according to changes signaled by the QAS Risk Zone indicator. This mechanism works very well to accommodate the main requirement by the ultra-conservative investor – reduction of drawdowns to a minimum.
At the same time, we want to make sure that when the QAS indicator turns positive, ultra-conservative investors get all of the financial benefits (capital gain including yield) associated with a high-yield investment. This includes both price and yield gains generated by global high-yield ETF instruments (US, EU, EM).
As a result, the QAS S-128 Global High-Yield w/ Max Protection Index’s back-test returned +14%/ 10-Yr CAGR% with maximum drawdown levels of 5% or less, and a Sharpe Ratio of 4.2.
Therefore, these “junk” bond investment instruments that are considered “high risk” can now become acceptable by the ultra-conservative investor. Our investment strategy is designed to minimize risk and maximize “yield” gains for the investors.
In addition, this investment solution can deliver annualized returns that are significantly exceeding desired “cash plus” (slightly exceeding risk-free rate) expectations.
Source: QAS Production, Yahoo.Finance
For more information please visit www.qas-service.com
*UK version of QAS S-128 Index has slightly different allocation scheme (QAS S-205).