High-Yield Bonds—Extra Income, But Added Risk
June 5, 2012
- In a world of low interest rates, high-yield (or sub-investment-grade) bonds can be a source of added income in an individual investor's portfolio. The yield on the Barclays U.S. Corporate High-Yield Bond Index is currently 8.2%—more than double the yield on the Barclays U.S. Intermediate Corporate (investment grade) Bond Index and more than 7.0 % greater than US Treasury bond yields of comparable maturity.1
- Over the past few years, improving economic growth and easing strains on financial markets have resulted in strong returns in the high-yield market.
- With interest rates on Treasury bonds near 40-year lows, higher coupon-interest payments have been especially valuable during the past few years. When reinvested, the compounding of interest income can help reduce volatility in a portfolio.
- However, extra yield comes with added risk: Companies that issue high-yield bonds are, by definition, less credit-worthy than investment-grade companies and are therefore more likely to default. In addition, the market for high-yield bonds is less liquid than for other types of bonds, and high-yield bonds tend to be more correlated with the stock market than with Treasury bond prices, potentially changing the overall diversification of your portfolio.
- We advise limiting the amount of aggressive income investments in a fixed income portfolio to 20% to help reduce potential volatility and losses.
With the Federal Reserve holding US Treasury yields near 40-year lows, investors seeking income often expand their search for higher yields into riskier sectors of the bond market. One such sector is high-yield bonds, which are rated below investment-grade because companies issuing them are less credit-worthy. The issuers may have more balance-sheet debt and weaker earnings power, and/or they may do business in more-volatile sectors of the economy, making their earnings less predictable.
Lower Credit Quality Corresponds with Higher Default Rates
Source: Schwab Center for Financial Research, with data from Standard & Poor's 2011 Global Corporate Default Study. The study analyzed the rating and default history of 14,654 US and non-US companies first rated by Standard & Poor's between December 31, 1981 and December 31, 2010. The 15-year cumulative average default rate is calculated by weight-averaging the marginal default rates in all static pools. Past performance is no indication of future results.
Because of these risks, less-credit-worthy companies must offer higher yields than those offered on investment-grade bonds. As of May 31, the yield on the Barclays U.S. Corporate High Yield Bond Index—where the average maturity is four years—is 8.2%, compared to 2.8% for the Barclays U.S. Intermediate Corporate (investment grade) Bond Index, with an average maturity of 5.3 years.
Over the past 25 years, the average ratio of the high-yield index yield to investment-grade was 1.74 compared to the current ratio of 2.92. This higher-than-average ratio implies that the market is pricing in a higher degree of risk in high-yield bonds than the historical average despite the fact that default rates for high-yield issuers are currently below the long-term average.
Default rates among high-yield-bond issuers have declined since the peak of the financial crisis, and the ratio of upgrades to downgrades within the sector has improved. The most-recent figures from Moody's indicate that average default rates are running at 2.2%, below the long-term average of 5.6% and significantly below the recent peak levels of 17.1% in 2009.
As the chart below illustrates, the high-yield market can be volatile. During times of financial distress such as the financial crisis in 2008-2009, or in the aftermath of the technology-stock bubble bursting in 2000-2001, yields spiked sharply higher—with prices declining steeply. When financial markets are under stress, liquidity can be scarce—both for companies seeking loans and in the high-yield market itself, as buyers retreat.
Recent improving financial conditions, as shown by the decline in the St. Louis Financial Stress Index, have been supportive of the high-yield bond market. (The St. Louis Fed's index is comprised of indicators such as interest-rate yield spreads and volatility indexes that measure ups and downs in the financial sector of the economy.)
St. Louis Financial Stress Index Versus Barclays High Yield Index
Source: Barclays Database and St. Louis Federal Reserve Bank, monthly data as of April 2012.
To some extent, the high-yield bond market has been experiencing a positive cycle. As interest rates have fallen and economic conditions have improved, companies have been able to refinance debt at lower levels, which has improved the measures of their financial performance. As those measures improve, investors seek out the bonds, pushing yields lower, which in turn allows for more refinancing.
Income is important
A potential benefit of high-yield bonds in the current environment is the relatively high level of coupon income. It's obviously helpful for investors looking to use that income to meet expenses, but it can also be beneficial when reinvested, because it can help dampen volatility in an overall portfolio when interest rates rise. In a rising-rate environment, higher-coupon bonds tend to decline less than bonds with lower coupons because the current income can be reinvested at higher interest rates, all else being equal.
Moreover, when interest rates are rising due to strong economic growth, the economic performance of companies that issue high-yield bonds may improve. As the chart below illustrates, returns for high-yield bonds over the past 10 years have been higher than for investment-grade bonds, but are significantly more volatile.
Annual Returns on High-Yield and Core Bonds
Source: Schwab Center for Financial Research, with data provided by Morningstar, Inc. Asset class performance is represented by annual total returns for the following indexes: Barclays US Aggregate Bond Index (core bonds), Barclays US Corporate High Yield Bond Index (high-yield bonds). Returns assume reinvestment of dividends, interest and capital gains. Past performance is no guarantee of future results.
Fitting high-yield bonds into a portfolio
One of the challenges in fitting high-yield bonds into a portfolio is that, over time, they've historically been more highly correlated with common stocks than with most other bonds. So, for investors with portfolios balanced between stocks and bonds, shifting some bond allocation into high-yield bonds might actually increase the volatility of the portfolio and reduce overall diversification. This is especially true in the recent environment, in which higher risk assets have tended to move together. High-yield bonds have been much more likely to move up and down with the stock market than with Treasury bonds.
Correlation of High-Yield Bonds to Other Asset Classes
Source: Schwab Center for Financial Research with data from Barclays Database and Morningstar, Inc. The asset classes are represented by the following indexes: Barclays U.S. Corporate High Yield Bond Index (high yield bonds), S&P 500® Index (US stocks), Barclays U.S. Corporate Bond Index (investment grade bonds), and Barclays U.S. Treasury Bond Index (Treasury bonds). Correlations are between monthly total returns from September 30, 1997 through March 30, 2012. Correlation measures the degree to which two (or more) variables vary together. Correlation coefficients range from -1.0 to +1.0, where -1.0 is perfect negative, or inverse relationship, and +1.0 is a perfect positive relationship; 0.0 implies no relationship. Past performance is no guarantee of future results.
High Yield Index and S&P 500® Index
Source: Barclays Database US Corporate High Yield Index and Bloomberg S&P 500 Index, daily data as of May 1, 2012.
Individual bonds, index funds, ETFs or active management?
For a high-yield-bond investor, the decision of how to invest is as important as whether to invest. However, due to the elevated risk of default compared to investment-grade bonds, we suggest that all investors diversify among issuers and market sectors.
Constructing a portfolio of individual high-yield bonds is for investors with a high level of confidence in their ability to assess the creditworthiness of the issuers, and who understand the ups and downs of the cycle. However, many investors prefer mutual funds or exchange-traded funds to help provide broad-based diversification.
For index-fund investors, we suggest looking at components of the index against which the fund is benchmarked carefully. Be cautious if a large proportion of the index represents the weakest or lowest-rated bonds. When financial conditions change, the lower-rated bonds could be a source of weakness in the index. If you invest in actively managed funds, we suggest looking carefully at a fund manager's holdings and investment strategy.
High-yield bonds can be a source of income for investors searching for yield. Improving economic growth and easing credit conditions are positive for the sector. In addition, high coupon income that can be reinvested and compounded at above-average rates can help mitigate some of the potential volatility in these lower-quality bonds. However, higher yields mean higher risk, so we suggesting limiting your allocation to aggressive income sectors to no more than 20% of an overall fixed income portfolio.
For more information on the potential benefits and risks of high yield / sub-investment grade bonds, please read the Schwab's Guide to Sub-Investment Grade / High Yield Bonds.
1. Barclays US Corporate High Yield Bond Index and Bloomberg U.S. Generic Government Five-Year Yield (USGG5YR INDEX), as of May 3, 2012.
For mutual funds, investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.
High-yield securities are subject to greater credit risk, default risk, and liquidity risk.
Past performance is no guarantee of future results.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Barclays US Corporate High-Yield Bond Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB+ or below.
Barclays US Intermediate Corporate Index is a broad-based benchmark that measures the investment-grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers that meet specified maturity, liquidity and quality requirements, with maturities of one to three years.
The St. Louis Fed's Financial Stress Index (STLFSI) is constructed using 18 weekly data series; interest rates (effective federal funds rate, two-, 10- and 30-year US Treasury, Baa-rated corporate, Merrill Lynch High-Yield Corporate Master II Index, Merrill Lynch Asset-Backed Master BBB-rated); yield spreads (yield curve: 10-year Treasury minus three-month Treasury, corporate Baa-rated bond minus 10-year Treasury, Merrill Lynch High-Yield Corporate Master II Index minus 10-year Treasury, three-month London Interbank Offering Rate-Overnight Index Swap spread, three-month Treasury-Eurodollar spread, three-month commercial paper minus three-month Treasury bill); other indicators (J.P. Morgan Emerging Markets Bond Index Plus, Chicago Board Options Exchange Market Volatility Index, Merrill Lynch Bond Market Volatility Index [one month], 10-year nominal Treasury yield minus 10-year Treasury Inflation-Protected Security yield [breakeven inflation rate], Vanguard Financials Exchange-Traded Fund [equities]).
Barclays US Aggregate Bond Index represents securities that are SEC-registered, taxable and dollar denominated. The index covers the US investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset-backed securities.
Barclays US Treasury Index includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. The index rolls up to the U.S. Aggregate.
The S&P 500® Index is an index of widely traded stocks.
Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.