From junk to high yield.
This article by the economics team at fixed income specialists Payden & Rygel – one of GSFM’s investment partners – takes a deep dive into high yield bonds and examines the investment case for investing in this asset class.
Are bonds dead? With US Treasury yields hovering near generational lows and some developed sovereign bond yields in negative territory, investors wonder: What’s the point? However, what if we showed that you could generate equity-like returns with bonds?
You may have heard the term “junk bonds” used to describe high-yield bonds, but we hope you will see this asset class in a new light by the end of this article. We believe high-yield bonds could be a part of most portfolios.
This article will review the evolution of the high yield asset class, critical features of high- yield bonds that give them the characteristics of stocks and bonds, and how past performance showcases their resilience in different investment environments. As ever, past performance is no guarantee of future results, but we urge you to read on.
High Yield 101
A high-yield bond is simply an instrument used as a type of corporate borrowing. A company issues a bond to borrow money from investors, promising to return the principal at maturity and offering a coupon (or interest) payment along the way. The company can raise money without giving away equity or ownership. For almost every bond issued by a company, a credit rating agency like Moody’s, S&P, or Fitch grades the issuer on their ability to pay back the debt.
If you were betting on who would be valedictorian in a high school, you would not pick the kid with a C grade. Instead, you’d go with the one who had an A. Similarly, rating agencies assign corporations a rating between AAA and D to reflect the company’s chances of defaulting. A bond rating lower than BBB is considered speculative grade. The derogatory term for it? Junk.
We prefer to call these bonds “high yield.” Why? Since the issuer is deemed less likely to pay back the bond (or loan) in full, the issuer pays a much higher coupon (or interest) payment to the bondholder to make up for that risk. These days, a US Treasury bond with a 10- year maturity will yield 1.6%, an investment-grade corporate bond will yield 2.2%, while a speculative-grade bond can yield 4.3% – the highest yield. In the last decade, the yield in excess of government debt averaged 4.9% for the US High Yield Index.
From junk to high yield: a journey from Rodeo Drive to main street
Investors have been lending to risky borrowers for a long time. Before the advent of rating agencies, you simply bought a bond and figured out for yourself the likelihood of default. In the late 1800s, default rates for all bonds were as high as 16% (figure one).
After credit rating agencies started assigning rating was given because the firm was new or insufficient information was found for mid-sized companies without a longer track record. In fact, “up to the 1970s—all new publicly issued bonds were investment grade” and the “only publicly traded junk bonds [were those that] had once been investment grade but had become ‘fallen angels,’ having been downgraded[1].”
In 1971, the Bretton Woods system collapsed and led to higher interest rates, increased inflation, and two back-to-back recessions in the late 1970s. A widespread credit crunch followed. In this environment, “banks curtailed lending to all but the largest and highest-rated companies[2].”
Michael Milken, a polarising figure to some, led a revolution in high-yield debt, with the firm he worked at, Drexel Burnham, becoming a market maker in high-yield bonds to fund leveraged buyouts and mergers and acquisitions. By 1983, more than a third of all corporate bond issuance was below investment grade. Milken recognised that the higher yields on these bonds more than made up for their relative likelihood of defaulting.
Fast forward to 2021, and the US high-yield bond market has evolved into a US$1.5 trillion behemoth with more than a thousand issuers who employ 18 million people in the US, including Netflix, Tesla, Ford, American Airlines, and MGM (figure two)[3].
Smaller market, higher yields, more income
Look at the Bloomberg Barclays Global Aggregate (‘Agg’) Bond Index and you won’t find much yield. The Global ‘Agg’ includes almost all investment-grade bonds and amounts to US$60 trillion of debt, with an average yield of just 1%. If you owned the entire index, you could generate US$600 billion in annual income.
On the other hand, the much smaller Global High Yield Index has a market value of US$2.3 trillion but an average yield of 5.8%. Despite its smaller size, this index generates US$130 billion in annual income[4]. To put that into perspective, the global high-yield market is just 4% the size of the investment-grade market but generates 20% of the income.
Indeed, income is at the heart of high-yield investing. Total return is a mixture of price return and income (coupon for a bond or dividends for a stock). When you break down the returns of the high-yield index, you will notice something surprising: a negative price return. The price return (or market value) of the index is negative because over time, some bonds in the index default, while some others have their market value fall when investors lose faith in issuers’ creditworthiness. The primary reason high-yield bond issuers pay a larger coupon is to compensate for a higher probability of default!
While defaults are part of the high-yield asset class, they aren’t the whole story. If you are buying an index or a fund that tracks an index, you own numerous bonds. Most will not default and will continue to provide coupon income. However, even if your bond loses its market value, your coupons are fixed, and they keep paying income as long as the business is viable and does not default or go bankrupt!
These coupons add up and are why high yield generates higher returns even when the bonds lose some of their value over time or default outright (see Figure 3). Since 1996, the US High Yield Index had an average return of 7.8% from coupons and -1.1% from price, resulting in a total return of 6.6%. Since 1986, the US High Yield Index has had an annualised total return of 8.2%. The S&P 500 returned an annualised 10.6% over the same period.
Balancing risk and returns
While 8.2% annualised returns over time might sound impressive to some, equity investors may disagree. The excess annualised return of 2.4% in equities adds up over time, but not without cost. Equity performance is accompanied by extreme periods of volatility.
Maybe you run a business with cash needs, or you are closer to retirement and focused on assets that generate cash flows for your living expenses. In these roles, you require less volatility in your cash flows or even a modicum of income, which equities typically don’t provide to the same degree as high-yield bonds.
Looking at the standard deviation of the index, we find that high yield has far less volatility than equities (figure four) but higher returns than most other bond indices, offering a balance between reliable income and overall total returns.
Caustic correlations to rates no more
Are you worried about rising rates? You aren’t alone, with US$6 trillion and counting of US fiscal stimulus and fears about rising inflation, many investors share your concern. Bonds don’t do well in periods of rising rates, or so goes the adage.
High-yield bonds, however, are less sensitive to changes in interest rates than investment-grade bonds[5]. This is due to the relative importance of prevailing US Treasury rates and the credit spreads (the excess yield compared to US Treasury bonds) in determining the return for high-yield bonds.
Since investment-grade bonds are not expected to default, risk free interest rates (US Treasury yield) make up most of the yield provided by these bonds. In contrast, high-yield bonds have to compensate for increased default risk, and the excess yield over US Treasury rates is a much larger driver of risk and return.
To illustrate how high-yield bonds behave during rising rate environments, consider credit spreads across economic environments. Typically, spreads widen in times when the economy is deteriorating, and vice versa.
Since the spread component of yield in a high-yield bond is much larger, it has a built-in cushion to help protect against rising rates. And since rates typically rise during periods of economic growth, that further improves corporate creditworthiness and the value of high-yield bonds. Consequently, increasing interest rates (or the risk free rate) have historically impacted investment-grade bonds more adversely than their high yield counterparts.
In short, if you stay up at night thinking the Federal Reserve might surprise the public and start raising interest rates, your high-yield bond portfolio should help you rest a bit easier.
No drawdown doldrums
What some investors fear most is missing the chance to sell at the market ‘peak’ and then waiting a long time for a recovery back to their high watermark. Market timing is tricky. While the March 2020 market panic recovered in record time due to fiscal and monetary relief, not all drawdowns snap back as quickly.
Since the beginning of 2008, high-yield bonds have only experienced four material drawdowns.
Only two drawdowns lasted more than six months. The value lost during the drawdown in 2008 was
-29%. February and March of 2020 saw the second-largest drawdown, down -12% through to 31 March 2020, and back up +22.2% through to 30 April 2021.
You might wonder, who cares? Well, if you need your money back, you might have to wait longer in equities, where drawdowns tend to be longer. After the Global Financial Crisis of 2008, for example, the US High Yield Index took less than two years to recover to pre-recession levels, while the S&P 500 Index took more than four.
What’s in your wallet?
The false dichotomy that you can hold either stocks for high risk and high rewards and bonds for low risk and low yields is not a helpful guide to investing. Every asset class has value if investors understand it better and don’t cling to preconceived notions. While high-yield bonds offer returns higher than other bonds, high-yield bond returns don’t match up to equity returns. However, high yield bonds see shorter drawdowns, less volatility, less sensitivity to rates, and a steadier income stream that could be useful for certain investors.
———-
You must be logged in to post or view comments.