March 08, 2022
A key question to ask when investing in any asset class is: Are investors being adequately compensated for the risk they are taking on? We asked Michael Chang, a senior portfolio manager at Vanguard, to shed more light on how Vanguard goes about answering that question for high-yield bonds.
“Investing in high-yield corporate credit is a lot like investing in its investment-grade counterpart,” Chang said. “In both cases, you’re looking at companies and trying to understand their financials and business prospects. The difference really lies with where the key risks are.”
For high yield, default risk is the crucial consideration. Analysts looking at below-investment-grade or “junk” bonds spend much of their time trying to determine the financial health of issuers and the likelihood that the issuers will repay their debt (or, in the event of bankruptcy or restructuring, what the recovery rate might be). To assess whether the compensation being offered is adequate, they need to understand and quantify the level of risk they would be taking on.
Doing that assessment is complicated by several factors that make high yield relatively inefficient compared with other slices of the fixed income market:
“The goal across all of our actively managed fixed income funds is to deliver competitive returns without taking on undue risk,” Chang said. “To do that, we have in place a dedicated, specialized presence in all major areas of the bond market, including high yield—it gives us the largest opportunity set possible for generating active return for our investors.”
How does our approach to high yield differ from some of our competitors’ approaches? Our investment philosophy centers on a higher-quality credit bias, with a focus on security selection and diversification as the way to outperform over the long term. Going down in credit quality is not a strategy that tends to work out well in the long run, and our fee advantage means we can be more patient and disciplined in waiting for better entry points to add risk.
High-yield bonds, like all fixed income instruments, have limited upside, so a key element in generating competitive returns is avoiding the land mines—bonds that get downgraded or restructured or that go into default. In security selection, we differentiate ourselves in our proprietary scoring matrix. We start by analyzing companies based on a common set of criteria, including their sensitivity to economic growth, the outlook for their industry, their competitive position within that industry, their level of patent protection, the quality of their management teams, and their financials.
“Those are pretty standard criteria,” Chang said, “but then we translate our assessments into scores that we use across all of the companies we look at. That allows us to do a few things: rely on our own credit assessment of companies rather than on those of credit-rating agencies; use our scoring to consistently compare companies to one another and across industries; and compare our assessment with that of the market to identify relative value opportunities within high yield that could translate into alpha.”
Our proprietary scoring system gives our actively managed bond fund managers another alpha lever to pull in their search for outperformance. And it allows them to better compare relative value opportunities across the fixed income universe. They can sit patiently on the sidelines when relative value opportunities in high yield just aren’t there, or be ready to invest when that asset class is offering adequate compensation for the risk involved.
All investing is subject to risk, including the possible loss of the money you invest.
Diversification does not ensure a profit or protect against a loss.
Investments in bonds are subject to interest rate, credit, and inflation risk.
High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings.