Few investments are as misunderstood as are high-yield bonds (HYBs). In today’s low-interest rate environment, HYBs afford investors significantly higher yields, making them a compelling and sought-after investment. Moreover they have proven to have effective diversifying characteristics with higher total returns than other bonds, and very favourable historical risk adjusted returns especially when compared to equity investments.
HYBs are high-income producing corporate bonds which fall below the investment grade category, based on ratings given by one of the major ratings agencies; Moody’s, Standard and Poors (S&P) and Fitch. An S&P rating below BBB- for example, suggests a bond has higher volatility with greater probability of experiencing a default, when compared to higher-rated bonds. Because HYBs have lower credit ratings and are more volatile, investors demand a higher interest rate – known as a credit risk premium.
What perpetuates the confusion surrounding HYBs is their tendency to have price action which correlates more with small capitalisation stocks than with bonds. Correlation is a statistical term which suggests that two sets of data have a predictive relationship or dependence among each other. Indeed HYBs have historically acted more like stocks than bonds, leading former US Treasury Secretary Laurence Summers to have once labelled them “equity in drag”.
Sound portfolio diversification and risk management are essential
Over the last 20 years the correlation between the Barclays High Yield Bond Index and the Barclays Government Bonds Index was a paltry -0.09, the correlation to the Barclays Investment Grade Corporate Bond index was 0.54 and to the Russell 2000 Small Cap Stock Index 0.63. Also when the global credit crisis hit in 2008, HYBs finished the year down roughly 17 per cent, more in line with the S&P 500’s 38 per cent sell-off than the iBoxx $ Invest Grade Bond index’s two per cent rally. Does this imply investors should avoid these seemingly more risky bonds?
No, quite the contrary, depending on economic conditions, HYBs can be a valuable diversifying tool. For risk-averse investors, adding equity exposure to a portfolio can be unsettling, considering equity’s higher risk. Thus HYBs can be an excellent substitute. Since the early 1980s, when the HYB market was established, they have returned about 9.2 per cent annually, about the same as the S&P 500. What’s more surprising is these S&P 500 like returns, have come with half the risk of owning shares.
Indeed since the early 1990s HYBs have on a risk-adjusted basis been one of the best performing investments, outpacing investment grade bonds, gold, US and European equities.
The biggest risk to owning HYBs is their risk of default; when a company stops making interest payments. Since 1971 the average US HYB default rate has been roughly 3.3 per cent annually. In the best of times defaults are low, but spike considerably higher, averaging 10-12 per cent, during recessionary times or as a financial crisis unfolds. During these times companies’ earnings plunge and meeting interest payments becomes more difficult. It’s important to note that low C-rated securities have significantly higher default rates than do better rated HYBs and considerable caution and analysis should be undertaken prior to their purchase.
Sound risk management is essential when investing in HYBs and a sensible portfolio management approach requiring a well-diversified portfolio of many different bond issues within diverse business sectors is highly recommended. Risk can be mitigated further by focusing solely on higher grade BB-rated bonds. Another perhaps more prudent option is to invest in a highly diversified and well-managed HYB fund or a HYB exchange-traded fund (ETF).
It’s important to not overpay for HYBs, particularly when credit spreads are too tight. A credit spread is the yield difference between risk-free government bonds and other bonds based on differences in credit quality, and are an important gauge of just how expensive HYBs are. Interestingly, because most HYBs have 10-year maturities, they have lower duration than investment grade bonds do, meaning their prices are less sensitive to interest rate changes. In a rising interest rate environment often HYB credit spread tightens due to the perceptions of an improving economy, which benefits HYB prices.
Empirical research clearly makes a case for diversified HYB exposure as they have relatively low correlations to most asset classes, making them excellent portfolio diversifying tools with good historic returns and relatively low annualised volatility. Depending on your risk tolerance both investment grade and HYBs should make up part of your portfolio. However, as always, sound portfolio diversification and risk management are essential to avoiding the pitfalls of owning the wrong bonds at the wrong times.
Joseph Portelli is the managing director and chief investment officer at FMG Funds (Malta). He is also a lecturer.