Given their more attractive valuations, we’ve updated our view on high-yield bonds. We think investors should now consider holding high-yield corporate bonds in allocations that are in line with their long-term strategic allocations.
Previously, we suggested investors reduce exposure to high-yield corporate bonds. Our underweight recommendation, made in summer 2019, was based our concerns about deteriorating corporate fundamentals. Investors were not being adequately compensated for those risks, in our view.
What changed? High-yield bond prices have dropped sharply, and the extra yield investors can earn from high-yield corporate bond investments relative to Treasuries has risen to its highest level in more than a decade.
However, this does not mean we suggest an overweight allocation to high-yield corporate bonds. We believe prices may fall further due to the deteriorating economic outlook, but we never try to time the market and call the bottom. Given the steep drop in prices, we believe investors can now consider holding them as part of a well-diversified portfolio.
High-yield total returns turn negative
High-yield corporate bond prices have tumbled over the past few weeks, and total returns are now negative for the year. High-yield corporate bonds offer high yields for a reason—they have low credit ratings and a greater likelihood of default. They’re often called “junk” bonds.
The year-to-date total return of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index was -18.1% through March 20, 2020, but most of the decline occurred during the past few weeks.
High-yield bond returns plunged during February and March
Source: Bloomberg. Cumulative total return from 3/20/2019 through 3/20/2020. Call-out box references returns from 2/20/2020 through 3/20/2020. Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.
The high-yield bond market has suffered like other riskier parts of the market, including the stock market. As investors weigh the potential impact of COVID-19 on both the domestic and global economy, the prices of many investments have declined significantly.
With economic growth widely expected to slow considerably, corporate profits are likely to drop sharply. Declining corporate profits and a drop in cash flow would likely lead to an increase in credit rating downgrades as well as an increase in corporate defaults. According to Standard & Poor’s, the combination of lower cash flows, tight financial conditions, and the oil price shock could pull the U.S. high-yield default rate above 10%. To put that into perspective, during the past three default cycles dating back to the early 1990s, the trailing 12-month speculative-grade default rate rose to 12.6% in 1991, 11% in 2002, and 12.1% in 2009.1
The plunging prices of high-yield corporate bonds likely implies that investors are already beginning to price in defaults. The average price of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index dropped to $81.5 on March 20th, the lowest level in more than 10 years. Prices did fall sharply lower during the depths of the financial crisis, ultimately dropping as low as $55 in November 2008, and they bounced above and below $80 in the early 2000s. If past recessions are any indication, additional downside is still possible.
High-yield bond prices have dropped sharply during recessions
Source: Bloomberg, using monthly data as of 3/20/2020. Shaded areas represent recessions. Past performance is no indication of future results.
Relative yields have risen sharply
A key reason for our underweight guidance was the low level of credit spreads. A credit spread is the additional yield that a corporate bond offers relative to a Treasury security with a comparable maturity. They are meant to compensate investors for the additional risks that corporate bonds offer, like the risk of default.
Corporate default risk has increased significantly, but so too have credit spreads. The average option-adjusted spread of the Bloomberg Barclays Corporate U.S. High-Yield Bond Index closed at 10.13% on March 20, 2020, its highest level since the financial crisis. While average prices have been lower than they currently are on a number of occasions, spreads have rarely been as high as they are today.
Keep in mind that spreads are just one metric to look at. While the credit spreads are at levels rarely seen before, the average yield-to-worst of the index is still just 10.9%, given the low Treasury yields today. Yield-to-worst is a measure of the lowest yield a bond could provide without defaulting; it’s the lower of the yield-to-call or yield-to-maturity. From 1987 through 2009, the yield-to-worst of the index averaged 11.3%, because Treasury yields were significantly higher than they are today. Since corporate bond yields are often based on the level of Treasury yields plus a “spread,” the low level of Treasury yields is one reason why the yield-to-worst of the high-yield index is lower today than during previous recessionary or crisis periods.
High-yield bond spreads have rarely been this high
Source: Bloomberg, using monthly data as of 3/20/2020. Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan.
What to do now
Given the steep decline in prices and rise in relative yields, we believe our previous guidance suggesting an underweight allocation to high-yield corporate bonds is no longer appropriate. For those who have been underweight, consider gradually adding exposure to high-yield corporate bonds, as long as any allocation is in line with your risk tolerance.
However, this does not mean we suggest investors hold overweight positions to high-yield corporate bonds. Prices might fall further due to the economic impact and ongoing uncertainty due to COVID-19. Holding some high-yield corporate bonds today can help provide higher income payments for those looking for higher yields, but be prepared to ride out the potential ups and downs of the market in the near-term.
You may want to use dollar-cost averaging to increase your exposure—by investing the same dollar amount at regular intervals over time, dollar-cost averaging can help you buy more securities when prices are lower and fewer when prices are higher. The high-yield bond market tends to be illiquid by nature, so given the risks and the high level of volatility, keep in mind that the size of an investment matters.
Finally, diversification is paramount in this environment of rising corporate defaults. If the corporate default rate does rise to 10%, as S&P expects,1 the prices of those defaulted bonds are likely to fall a lot more than the average price of the broad index. If you’re interested in high-yield corporate bond funds, you can explore some options on the OneSource Select List or the ETF Select List.
1 Source: Standard & Poor’s, “The Global Recession is Likely to Push the U.S. Default Rate to 10%,” March 19, 2020.
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