December 2022 – The Importance of Time Horizon

Dear Investors and Friends,

Why should an investor allocate capital to short duration high yield corporate bonds (SDHYCB)?  Mike and I get asked this question fairly frequently and the purpose of this letter is to provide our perspective on an answer.

Superficially, I believe the point most people are trying to make when they ask this question is that SDHYCB investments feel like they have the risk profile of an equity investment but without the higher long-term returns of an equity.  The implication being that the investor is getting the worst of both worlds – higher risk with lower returns.  We believe the exact opposite.  When executed well, we believe SDHYCB investments fill a much needed and often overlooked niche in an investor’s portfolio.

Long Term Expected Returns: Equities Win

To be completely clear, for capital that has a time horizon of ten years or more, there is no substitute for equities.  Over long periods of time, equities have historically always outperformed bonds and we see no reason why that trend will not continue.  For example, had you invested in the S&P 500 ~34 years ago, your compound annual return would have been 10.47% vs. 7.99% for SDHYCBs.

It should come as no surprise that equities outperformed SDHYCBs over this long-term period.  In general, equity holders take more risk than bondholders:
•    Equity is lower in a corporation’s capital structure
•    Equity, unlike bonds, do not have contractually defined payment terms.

Because equity holders take more risk, they demand higher returns. But before you allocate all your precious capital to equities there are other variables that one must consider if you want to engage in non-speculative investing.

Real World Framework for Understanding Risk

Investors and especially investment professionals like to talk about risk and why one strategy is “riskier” than another. From our perspective, those discussions can feel esoteric, abstract and just plain useless even to professionals like us. So, while there are many ways to evaluate risk, at RCM, we typically use just two metrics to quantify risk and neither utilizes math any more complex than what you learned in elementary school. These methods are:

• Years to Recovery: If I invested in this strategy at the worst possible time, how long would it take me to get my money back?
• Drawdown: If I invested in this strategy at the worst possible time, how far down would I be at the trough?

Let’s evaluate equities and SDHYCBs through the lens of each risk.

If I invested in this strategy at the worst possible time, how long would it take me to get my money back?
As represented by the highest point on the chart below, had you invested in the S&P 500 on September 1, 2000, you would have been investing at a market top right before the Dot.com bust. It would have taken you 6.13 years, all the way to October 20, 2006, to simply breakeven. And that includes the reinvestment of dividends.

Over the last 34 years, as the above chart shows, there have been two times that it took the S&P 500 at least 4 years to recover. While these long-term recovery periods do not happen often, they could be devastating to an investor that does not have a sufficient time horizon.

Compare these long recovery periods for equities to SDHYCBs. The max time to recovery for SDHYCBs over the last 34 years was 1.1 years. Why so much less than the equity max? The primary reason is structural. Bonds have maturities; this is the contractual date that the issuer of the bond is required to pay the bondholder back. Because time to maturity is relatively limited for a short-term performing bond the “pull to par” is relatively fast. So, the catalyst for recovery for a short-term performing bond is simply time.

Short duration bonds have provided 76% of the return of equities while not exposing investors to the significant time to recovery risk of equities. They are an excellent option for investors that do have the luxury of the long-term.

While not as large as equity drawdowns, SDHYCBs are not immune from market tumult. As the chart above shows, equity and high yield selloffs tend to be highly correlated but the magnitude of SDHYB drawdowns is significantly smaller.

Critically, while bond structure does not protect from drawdown because drawdown is largely a function of fear, it does protect from a long time to recovery. This knowledge is frequently overlooked - if the market for SDHYCBs is down significantly, you know that over the last 34 years it has always recovered quickly. For astute investors, that understanding can lead to excellent returns. However, because defaults will happen, the key is to do so with the expertise that you are allocating capital to credits for which you are being compensated for taking default risk.

Key Investment Principle

The long-term historical returns of an investment strategy provide a decent indication of the risk and rewards that one can reasonably anticipate over the short, medium, and long term. The analysis we performed here shows that there is no question that over the long-term equities will outperform SDHYCBs. However, the analysis also indicates that just because equities will generate the highest returns, they are not necessarily the optimal investment for capital that an investor wants peace-of-mind will be available in the next 3 – 5 years. An investor’s time horizon should be the primary variable that dictates the types of investments that one makes. While we only evaluated two asset classes in this month’s letter, this is a key principle that RCM routinely applies when advising clients about the most appropriate asset classes in which to invest given their constraints.

The prior analysis was all conducted on market indices. It is important to note that RCM, given its active management approach, has and should continue to meaningfully outperform the benchmarks in the areas in which it is allocating capital.

Please reach out to us with questions and comments. Thank you for trusting RCM with your capital. It is a privilege for us to serve you.

David and Mike