The January Effect In High Yield Bonds

With markets around the world off to strong starts in 2012, many market pundits have made mention of the January effect. This phenomenon states that tax-selling pressure at the end of the previous calendar year drives down equity prices, leading to outsized gains in the following January. This anomaly has become such a widespread legend in financial markets that efficient market proponents would expect that this arbitrage would be priced out of the market. After analyzing the latest historical returns, it does appear that this calendar effect in domestic equity markets has been muted in recent periods. For both the trailing five and ten years, January has been the second to worst month in the sample for the S&P 500 (SPY).

Click to enlarge:

Other market prognosticators conjecture that the January effect in equities is not an absolute, but rather that it signals relative outperformance of small-cap equities versus large-cap equities. To observe this relative performance of small caps and large caps, the calendar effect of the S&P 500, as a proxy for large caps, and the Russell 2000 (IWM), as a proxy for small caps, was examined. Over the last ten years, the difference between small cap returns and large cap returns in January finished only in the middle of the pack of monthly returns (ranked ascending by outperformance of S&P).

Click to enlarge:

It does not appear that a calendar effect has been a bankable trade in the U.S. stock market. However, in another domestic market, the January effect remains substantially positive - high yield corporate bonds. Examining the Barclays U.S. Corporate High Yield Index, January returns have far outpaced all other months. From 1984-2011, returns in January have averaged 2.08%, an annualized return of 28%. These figures far surpass the second most positive month, December, which has seen an average monthly return of 1.44% or 18.7% annualized. December and January have also seen lower variability of returns over the life of this high yield index, presenting the rare opportunity to achieve abnormal returns on average for less than market risk.

Click to enlarge:

Examining January returns over the sample period, compared to a time series of the average returns of all other months demonstrates that the January outperformance is statistically significant. The January effect is also present when subdividing the high yield index by its ratings strata. The January effect strengthens as we go down the ratings spectrum.

As we move quickly through the early part of 2012, it may be time to re-think your allocation to high yield bonds and closed-end funds holding high yield bonds. Nearly half of the annual high yield return has been earned on average in December thru February. In single-Bs (52%) and triple-Cs (61%), an even greater proportion of the total return is captured in these months. There seems to be a seasonality to high yield investments that is not present in the investment grade universe or in equities, and grows stronger as we move down the ratings spectrum. My speculation is that institutional investors' desire to class up their portfolios at year-end by reducing weights to speculative grade credits could be contributing to this phenomenon. Insurance companies, who are large holders of corporate bonds, face increasing capital ratios as they move down the ratings spectrum (4.6% for BBs, 9% for Bs, 17% for CCCs), and may desire to reduce allocations to high yield bonds to improve year-end stautory risk-based capital ratios.

Looking at a sample of quarterly price returns of some of the larger high yield bond closed-end funds with a minimum ten year history, AWF, DHF, HIX, HYB, HYF, VLT, demonstrates that the first quarter typically outperforms the second quarter.

Click to enlarge:

The difference in first quarter average performance of 3% and second quarter average performance of 0.2% is greater than the typical quarterly distribution. This effect is not simply a function of the macro backdrop as the S&P 500 (SPY) outperformed on average in the second quarter versus the first quarter for the same sample period.

It appears that the January effect or seasonality effect is still present in high yield bonds, and you should consider re-weighting your asset allocation accordingly. If you are bullish on the market, consider swapping into equities in the near-term. If you are bearish, consider increasing your allocation to cash or investment grade bonds. Against both asset classes, high yield bonds seem to richen from December to February on a relative basis versus asset classes where the January effect is no longer pronounced.

Disclosure: I am long SPY.