Why diversification is essential in high yield

• Many investors think that by increasing concentration you increase the potential upside of an investment. This is true to an extent in equity investing as the theoretical upside is unlimited.
• However, this does not apply to fixed income as the upside of any one bond is limited to the yield and the downside is 100%.
• This is even more true in high yield as the risk of a default is elevated.
• Below, through illustrative examples, we will show that high yield concentration does not add any further upside return, increases downside risk and leads to much weaker liquidity.
• However, there is a sweet spot for diversification, that is you want to have enough to manage downside risk, but not too much to dilute the best ideas in the portfolio.
• An effective way to achieve this optimal level of diversification is through a fund.

Why diversification is essential in high yield

Even if the high yield positions are only a small part of a wider portfolio, by using a diversified portfolio or fund the long term return will likely be higher than owning a concentrated number of high yield positions as the negative impact of defaults on the wider portfolio can be minimised without giving up yield.

Many investors own high yield bonds to maturity with the goal of clipping the coupon (i.e. buying the bond to maturity with the goal of achieving a pre-specified yield). However the dangerous assumption here is that the company won’t get into trouble and have to restructure causing a permanent loss of capital. We like to say the strategy of clipping coupons in high yield is like picking up coins in front of a steam roller. Investors can still benefit from the attractive coupons in high yield, but one way to do this in a sophisticated manner is through the use of a fund that diversifies, takes an active approach, which aims to avoid problem companies, and pays out income.

• The upside of any bond is limited (capped) to the yield.
• The expected return of any bonds will be lower due to the expected probability of a default event.
• A fund can add extra yield through investing in subordinated CCC bonds where the higher risk of these bonds can be managed.
• Bottom line: There is marginal to no difference in a concentrated bet within high yield versus a portfolio of high yield bonds.

• As the upside is limited and the downside is significant, by diversifying across more positions the risk/reward profile becomes increasingly attractive.
• Expected returns remain within a tight range, but the risk significantly falls as you diversify with more bonds (less weight per bond).
• Bottom line: With the improving risk/reward profile, when investing in high yield bonds it makes sense to invest in a diversified portfolio or fund of at least 100 bonds. As the minimum tradable amount of any bond purchase is usually greater than 100k, for an investor to build a diversified portfolio on their own they will typically need a portfolio of more than $10-15mn.

• In high yield, liquidity of any one bond varies over time due to a number of factors such as upcoming earnings and news events. By investing in high yield through a diversified portfolio or fund, short term liquidity needs are usually improved by spreading sales across a wider number of bonds.
• Typically, the lower the rating, the higher the cost to trade.
• If the bond becomes distressed the cost to trade can be as high as 5% and may take a number of weeks.
• Bottom line: A diversified portfolio or fund reduces the liquidity cost given closer market access, ability to time sales and ability to spread sales across bonds.

In summary, we think that it is essential to diversify in high yield as it a) increases risk/reward, b) minimises the negative impact of a default, c) allows for cheaper and faster market access/liquidity. An effective way to diversify is through a fund.

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