Case for High-Yield Bonds (Advance)
What Are High-Yield Bonds?
High-yield bonds, otherwise known as “junk bonds”, are issued by organizations that do not qualify for “investment- grade” ratings by one of the leading credit rating agencies – Moody’s, Standard & Poor and Fitch Ratings.
Credit rating agencies evaluate issuers and assign ratings based on their opinions of the issuer’s ability to pay interest and principal as scheduled. From the table of credit rating definitions, bonds rated Baa or BBB and above are considered investment-grade securities. Bonds rated Ba or BB and below are high-yield bonds, and generally have default rates in a range of 2-8% per year.
These issuers are usually
1) Newer, emerging companies raising money for expansion
2) Older companies which have weak balance sheets and/or weak profits
3) Companies taking on large debts for acquisitions or leveraged buyouts
It may surprise you to know that some of the top companies in the Fortune 500 have had debt obligations that were below investment grade. For example, in 2005, Ford and General Motors both fell into high yield bond status for the first time in either company’s history. Other companies like Advanced Micro Devices, Inc. (AMD) are currently having high yield status. Many investors will gladly hold common stock in these companies, but wrongly fear and avoid high yield bonds of these companies. It may be due to investor’s misunderstandings and lack of knowledge of the asset class. Remember high yield bonds are definitely less risky than equity.
Investment Features/Characteristics
Yield Spread
High-yield bonds have higher interest coupons, than investment grade bonds as the companies have to compensate for the risk of default losses, but also partly to compensate for the lack of liquidity in the high-yield bond market compared to the Treasury market. The yield spread is the extra yield of high-yield bonds over Treasuries securities, calculated with the interest coupons as the main variable, has historically fluctuated around a spread of approximately 450 basis points.
Price Sensitivity to Interest Rates
The higher yields also enhance the long-term returns attributable to the power of compound interest. It also shortens the “duration” of a bond, a measure of a bond’s sensitivity to changes in interest rates. Thus meaning, high-yield bonds are less price sensitive to interest rate raises. Bond prices will decline as interest rates rise, and bond prices will climb as interest rates fall.
Price Sensitivity to Credit Risk and Economic Conditions
The fluctuations of high-yield bond prices to credit risks are greater than that of investment-grade bond prices because high-yield bond issuers’ credit quality (perceived and rated) is less predictable than investment-grade companies. All else being equal, high-yield bond prices will rise as economic conditions improve and perceived credit risk drops. In financial language, when yield spreads tightens (also called narrows or drops), prices of high-yield bonds increase.
Default Rates
While defaults are costly, bondholders will typically recover a portion of their investment even in a bankruptcy situation. The historic average default loss is approximately 60% of face value. Therefore high-yield bond returns have reduced, on average, approximately 3% per year (60% of 5%) due to default losses. To compensate for these portfolio losses, high-yield bonds pay higher interest rates than investment-grade bonds.
Correlation
The total return of high-yield bond returns are somewhat unique, coming from both interest coupons and capital gains. The high interest coupon component of high-yield bonds forms part of the returns, just like an investment grade bond. In addition, returns of high-yield bonds also come from capital gains made from credit risk and economic environment improvements.
High-yield bonds have less volatility than stocks and more returns than investment grade bonds. High-yield bonds help to diversify portfolio returns considered within the classic framework of diversification and asset allocation as they have relatively low correlation to investment-grade bonds and stocks.
Efficient Frontier of High-Yield and Treasuries Mix
Efficient Frontier of Diversified Portfolio
High-Yield Bond Funds
The high-yield bond market has developed over the years as an “institutional” market and market activity is led by large institutional investors. Single bond trade is denominated in a “round lot” of one million US dollars of face value. In addition, individual high-yield bond issues have an extremely wide variation of risk and returns requiring expert knowledge.
This and other factors means that the most effective way for an individual investor to participate in the high-yield bond market is through the ownership of shares in a well-diversified high-yield bond mutual fund.
Most funds seeks high current income, with capital appreciation as a secondary goal. High-yield bond funds also pay monthly or quarterly distributions of income. Bond fund distributions will change over time. Do not assume that the payments on a bond fund today will remain the same in the future.
Pass Trends
The high-yield bond market was a specialty niche market in United States, with the bulk consisting of “fallen” big corporations prior to 1980, but has grown very rapidly during the past 25 years. As at 2006, it represented approximately US$1 trillion of bonds from over 1,000 different issuers. Currently, US companies still accounts for 80% of the USD high-yield bond market in the world.
Pass cycles have shown that in the years after a crisis, when the yield spread is tightening after the jump, returns of high-yield bonds perform the best. Followed by more constant good returns during years of low spreads.
Default rates will be remain low in years of recovery.
In 3 years follow the last 2 recessions, high yield has captured more than S&P 500’s returns with almost half the volatility on average.
| Time Period | High-Yield Returns | S&P 500 Returns |
| 1991 – 1993 | 86.34% | 54.51% |
| 2003 – 2005 | 44.91% | 49.67% |
| Average | 65.63% | 52.09% |
| Time Period | High-Yield Volatility | S&P 500 Volatility |
| 1991 – 1993 | 4.77% | 10.55% |
| 2003 – 2005 | 5.03% | 9.04% |
| Average | 5.04% | 9.80% |
Current Expectations
High-yield bond market has seen its best days in 2009. History shows that, just as with equities, high yield tends to generate the biggest percentage gains in the first year of recovery. Though easy to see on hindsight, ample risk exists during the time and investors are hard pressed to have confidence. Returns have remained attractive so far in 2010, with the benchmark up 8.12% through the end of July. At 8% to 9%, yields on high-yield bonds are the most attractive in U.S. fixed-income and I see this lasting some time.
As economic environment improves, defaults are minimal, recovery rates are relatively high, net new issuance in the face of rising demand is minimal and companies paying down debt—all positive for valuations. Since the beginning of 2010, the downgrade/upgrade ratio for high-yield issuers has materially reduced, and the Moody’s expects that the trend in H2 2010 will be for upgrades to outpace downgrades. Moreover, unlike equities, which tend to need GDP growth in the 4% to 5% range for some real pop, high yield is best with the current 2% to 3%. Stronger growth would be a bonus, but attracts interest rate raises.
Current yield spreads on bonds rated below Baa3 by Moody’s and BBB- by Standard & Poor’s is about 650 basis points, according to Bank of America Merrill Lynch index data. This creates a small window of opportunity for the yield spread to narrow to average 500 basis points.
Short-term and US government interest rates are bound to rise at some point. That said, 10-year U.S. Treasury yields may remain in the 3% range till 2011. This gives a window of about a year of strong relative performance. Much of the rise in U.S. Treasury rates will most likely be absorbed by spread tightening.
Risks
In financial language, the following risks exists in investing in high-yield bonds.
Credit Risk – Potential for loss resulting from an actual or perceived deterioration in the financial health of the issuing company. Two sub-categories of credit risk are default and downgrade risk.
– Default risk refers to defaults that occur when a company fails to pay an interest or principal payment to a debt holder as scheduled and as specified in the legal agreements.
– Downgrade risk refer for to downgrades resulting when rating agencies lower their rating on a bond. Downgrades are usually accompanied by bond price declines.
Interest Rate Risk – Interest rate movements affect the price of high yield securities. High yield bonds tend to have shorter maturities of 3-10 years compared to higher quality securities.
Liquidity Risk – High yield bonds can sometimes be less liquid than investment grade bonds, depending on the issuer and market conditions at any given time.
Economic Risk – During recessions, high yield bonds tend to sustain higher price falls compared to investment grade bonds.
Company and industry “event” risk – This encompasses a variety of pitfalls that can affect a company’s ability to repay its debt obligations on time. Events that adversely affect a whole industry can have a blanket effect on the bonds of its members.
In the context of high-yield bond fund investments, the following risks will be more relevant for consideration. Firstly, high-yield bonds has flourished in 2006-2007 in part due to collateralization of loans that provided capital for a large number of deals. The cycle comes to end starting 2011, when the deals require restructuring or matures.
Moody’s believes that the default rate may rise again in 2011-2014, as some more weakly positioned credits struggle to refinance.
Unemployment and consumer spending is also a concern. Consumers are required to drive the U.S. economy. If consumer buying erodes on high unemployment, it could cause revenue and cash-flow shortfalls across many sectors and companies. This scenario would result in a rising default rate and spread widening.
Lastly, though chances are slim, the Federal Reserve’s actions and interest rates can hurt returns. A change in the Fed’s philosophy or a spike in rates could hurt issuer credit ratios and fixed income asset values. Fortunately, high yield generally has limited correlation to interests rates
For selection of a fund, look at what has happened to the fund’s total return during past downturns. An extremely high turnover (over 200%) may be an indication that near-default bonds are being replaced frequently. The fund’s average credit quality will show you if the majority of the bonds being held are just below investment-grade quality at ‘BB’ or ‘Ba’ or ‘CCC’ or ‘CC’, meaning the fund is highly speculative.
In Conclusion
The addition of these high-yield bonds to a portfolio can actually reduce overall portfolio risk when considered within the classic framework of diversification and asset allocation. The weightage of high-yield bond in the portfolio will depend on the current situation. The attractiveness of high-yield bond now is more tactical and situation in nature.
Interesting articles:
Guide to investing in high-yield bonds
PineBridge Investments high-yield bonds outlook
Aegis high-yield bond fund
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