The Case For High Yield Bonds

The Case for High Yield Bonds

In the 1970’s and 80’s, if you wanted to buy a low-quality company’s bond, you would in essence be buying a “junk” bond.  There was a certain stigma associated with these types of bonds, mainly because no one wants to own “junk.”  In a brilliant marketing strategy developed by Wallstreet, the category was re-branded in the early 1990’s to “High Yield” Bonds.

High yield bonds are bonds issued by lower credit quality companies, that pay a higher interest rate than their quality counterparts. High yield bonds carry more risk than investment grade or quality bonds, because they inevitably have a higher default rate and lower credit rating.  They also historically carry less risk than stocks because they have lower volatility and are higher up the repayment schedule.

As with any investment, there are good and bad times to be an investor of high yield bonds.  One of the many aspects the Strategic Income Group Investment Committee tracks in determining the right time of owning these types of bonds is the “spread.”

The spread is simply the difference between what high quality/ government bond pays and what a high yield or junk bond pays.  On average, the difference is roughly 500 basis points (5%).  That means that if a quality bond is paying 2% annually, you would expect a high yield bond to pay approximately 7% over that same time.

Whenever things are going well in the economy and markets, the spread level decreases.  This happens mainly because during good times, investors tend to ignore the amount of risk they are taking on so fewer quality companies can issue bonds for a lower interest rate.  In times like these it is not conducive for investors to purchase high yield bonds because they are not being compensated enough for the amount of risk they are assuming.

On the flipside of the good, whenever things are not going so well, or there is distress in the economy or markets (Coronavirus anyone), the spread level tends to widen out.  The widening of the spread levels is due to investors not wanting to take additional risks and the fear of defaults in high yield bonds during these periods.

As illustrated in the chart below, high yield bonds have outperformed quality bonds over the past 20 years, regardless of spread levels.

The Opportunity

The Coronavirus pandemic currently taking place has caused unprecedented market volatility and economic uncertainty spreading beyond the financial markets.  With the uncertainty caused by the virus, high yield spreads briefly surpassed 1000 basis points (10%), and remain today at elevated levels not seen in a decade.

When investing in the high yield space during times of heightened credit spreads, the return of high yield bonds has historically been stellar. The chart below indicates that when investing into high yield during times of elevated spread levels, an investor has achieved positive returns after 3 years 100% of the time (past performance is no guarantee of future results, which can and will vary).  To summarize, wider spreads coupled with longer time horizons have resulted in attractive returns in the high yield market.

Source: ICE Indices, Morningstar Dec 31, 1999 – February 29, 2020.

While high yield bonds are fixed income investments, the return profile during times of elevated spreads appear more similar to the return of stocks.  Usually these extremely elevated spread levels do not remain for long and revert back to the normal levels, causing high yield bonds to appreciate in a relatively quick time frame.

Knowing that high yield bonds typically perform very well during times of elevated spread levels, we also wanted to look at their performance relative to stocks during times that spread levels begin to tighten back to normal.  As the chart below illustrates, when spread levels have gotten extremely wide, high yield bonds have not only outperformed stocks, but they have done so by a significant margin.

Source: ICE Indices, Morningstar, 12/31/1999 – 2/29/2020 High yield represented by the ICE
BofA US High Yield Index. Stocks represented by the S&P 500 Index.

Federal Assistance

As part of the recent stimulus package that was rolled out by the Federal Government and Federal Reserve, in an unprecedented move, the Federal Reserve is committed to buying high yield bonds (up to 10% of the high yield market).  The Federal Reserve is purchasing these bonds to keep liquidity flowing in the high yield market and prevent what could be a large default rate due to the economic shutdown.

With the new assistance from the Feds, this serves as somewhat of a backstop to the high yield market, making it that much more attractive of an investment going forward.

Conclusion

The high yield bond markets currently present an attractive investment opportunity for some portfolios due to the unusually wide spreads that exist.  Couple that with the feds stepping in and committing to purchase the asset class in a big way, and taking into account historical data, the high yield bond market could produce a return that is greater than normal in the near future.

Remember, discipline is the key to success.

Strategic Income Group Investment Committee

Chad Manberg, CFP, Michael Gauthier, CFP, Bob Stamm, CFP, Laurie Simons, CFP

*This article is for education purposes and does not represent a solicitation of investments.  All investment advice given is based on a client’s financial plan.  Past performance is not indicative of future performance.  Investment advice offered through Strategic Income Group, an SEC registered investment advisor.