Bonds have long been included in most investment portfolios because they can provide investors with monthly income and mitigate downside risk in turbulent equity markets. Over the last 40 years however, the yields available from fixed-income bonds have been in decline and correlation with equities has become increasingly positive. As a result, investors have been forced to accept lower yields from issuers or explore income investments outside of the typical investment grade corporate bond and government bond arena. One such alternative that has grown increasingly prevalent are bonds considered below investment grade, known as high yield bonds.
Correlation (S&P 500, 10 Year Treasury Bond)
Bonds and Treasuries are not negatively correlated as they once were.
What is a High Yield Bond?
Companies often issue bonds to borrow capital for business expenses in exchange for monthly interest payments. The amount of interest than an issuer will need to pay is determined by the credit rating of the company. Larger, more-established companies have an advantage because their scale and cashflows allow them to pay lower coupons due to their perceived safety. These bonds are considered investment grade because there is a high probability that they will be able to make payments within the terms of the bond. But what about smaller, newer, or private companies seeking to borrow money? Those companies, with lower credit ratings, issue what we refer to as high-yield bonds. Just as the name suggests, issuers of high yield debt must make higher interest payments to bond holders to entice investors to assume greater risk that the company may default on a payment. Because the bonds are considered more speculative as investments, they are also known as below investment grade or colloquially, junk bonds.
Benefits of High Yield Bonds
In spite of their increased default risk, investors reach for high yield bonds because of the benefits they may offer. Provided they are part of a well-diversified portfolio, high yield bonds can add value for investors in the following ways:
1. Increased Income
As the name suggests, the primary benefit of high yield bonds is the enhanced yields that they provide in comparison to their investment grade corporate and especially treasury counterparts. Investors have historically received a spread premium in the neighborhood of 300-500 basis points depending on broader market conditions like inflation or changes in the supply and demand of credit. In periods of extreme uncertainty, the yield premium can balloon well beyond 500 bps. In fact, the spread between high yield bonds and the spot treasury curve as measured by the ICE BofAML US High Yield Master II Option-Adjusted Spread Index exceeded 2000 bps in the height of the global financial crisis in November 2008.
The Gap Between Fixed Income Yields and Inflation is Closing
1 Treasury bonds represented by average daily yield on 30 year treasury bond in 1998. 2018 data as of December 31, 2018.
2 Municipal bonds represented by average daily yield of Bond Buyer 20-Bond Municipal Bond Index in 1998. 2018 data as of December 31, 2018.
3 IG corporate bonds represented by average daily yield of Moody’s Seasoned Aaa Corporate Bond Yield (AAA) in 1998. 2018 data as of December 31, 2018.
4 Certificates of deposit represented by average daily yield available on a 6 month certificate of deposit in 1998. 2018 data as of December 31, 2018 via Bankrate.com.
In addition to offering enhanced yields, high yield bonds as an asset class can add meaningful diversification as well. High yield bonds generally feature lower correlation to investment grade corporate and treasury bonds (0.09 and -0.14, respectively5) which can potentially smooth out a portfolio’s market value in volatile bond market conditions. While diversification cannot reduce risk of losses to zero, including less correlated securities alongside traditional fixed income assets can help decrease overall portfolio risk.
3. Potential for Capital Appreciation
The coupons that high yield bonds pay bondholders are not the only source of return that they offer. If there is strong performance from the issuing company, the industry the issuer is a part of, or the economy at large, there is a potential for capital appreciation as well which investors can capture should they choose to exit their position to pursue other opportunities in the markets. Circumstances that could potentially cause capital appreciation in high yield bonds (or any type of bonds) include upgrades to the issuer’s credit rating, positive earnings reports, new or improved product developments, and positive market-level sentiment. Of course, capital appreciation is only possible in situations where a secondary market exists for a high yield bond. It is more typical to hold a bond to maturity and even more typical to access high yield bonds via investment funds as opposed to at the individual level, which may not even be possible for an individual investor.
Risks of High Yield Bonds
The potential benefits of high yield bonds do not come without increased exposure to a few kinds of investment risks. In comparison to investment grade corporate and government bonds, high yield bonds have a higher risk of default and are generally more volatile in terms of their current market value. Over longer investment horizons high yield bonds exhibit premium returns, especially if purchased at a discount to par value.In the short-term however, high yield bonds are subject to swings in value and heightened defaults when economic conditions become less favorable. Because of their risk-return profile, it is imperative that investors are diversifying properly across issuers and market segments. A typical way for investors to access high yield bonds with a degree of diversification is through investment funds that make use of them rather than investing in single bonds.
A diversified portfolio containing a variety of asset types, market sectors, and geographies will help investors work towards their goals and avoid the potential of a significant loss from any single event. Diversification is not a guarantee against investment losses.
To learn more about high yield bonds, please contact your financial professional.