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How Have High-Yield Corporate Bonds Fared During Recent Volatility?

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RANDY FREDERICK: For the first 10 months of the year, high-yield corporate bonds have been doing quite well. But, lately, things have gotten a little volatile. Collin Martin joins me for the November 28th Schwab Market Snapshot to give us his take on what’s been going on, and whether or not it’s likely to continue.

Collin, it seems like high-yield bonds have been in the news a lot lately. We’ve seen a lot of volatility and some pretty sizeable price declines. So can you give us your perspective on what’s been going on?

COLLIN MARTIN: Well, beginning in late October, credit spreads began to rise. Credit spreads are the additional yield that corporate bonds offer relative to treasuries to compensate for the additional risks that they have. And because bond prices and yields move in opposite directions, when spreads are rising, prices are generally falling.

Now, when all is said and done, the average spread of the Bloomberg-Barclays High-Yield Bond Index rose by more than 50 basis points, or more than half a percentage point from October 24th through November 15th. Now, that may not seem like a lot, but it was enough to push the total return of the index into negative territory for that time period--it lost around 1½ %.

Now, we see a few key reasons that might have led to this volatility. The first is that interest rates have been rising. That’s generally a negative for issuers because it makes it more expensive to refinance their debt. The second could be the tax debate going on in Congress, especially the point that could limit the amount of interest expense that can be deducted from an issuer’s taxable income. Because high-yield bonds generally have aggressive risk profiles, just a minor negative impact to their cash flows can increase their risk of default.

RANDY: I mean, you know, that all makes sense, but one thing I’ve noticed is that it seems like almost as quickly as this volatility came, the market has reversed itself. Some of these bond prices have recovered, and the volatility seems to have come back down. So can you tell us does that mean that the panic is over, or is it possible we might see another flare-up in the near future?

COLLIN: Well, we’re not, necessarily, expecting another flare-up in the near future, but this should serve as a friendly reminder of the volatility that high-yield bonds do offer. Now, what’s important to recognize is that prior to the rise in spreads, spreads were very low. In fact, the average spread of that Bloomberg-Barclays index was at a roughly 10-year low at the end of October.

And even with the reversal back down a little bit today, we’re still well below historical averages. So even though high-yield bonds do come with additional risks, the additional yield that investors are getting today is pretty low.

So we have two important takeaways from this recent volatility experience. And the first is that investors should understand that high-yield bonds do have a lot of volatility and they are prone to price declines. You need to be aware of that and make sure your risk profile matches the risk profile of high-yield bonds.

And the second is that even though price declines can impact short-term performance, the higher coupons that high-yield bonds offer can help offset some of those price declines over longer investing periods. So, for example, the total return of that index for the year through November 27th, is plus 7%. So if you’re interested in high-yield bonds, understand the risks that they offer and make sure if you do own them that they’re part of a well-diversified portfolio. They should serve as a complement to high-quality investments and not as a substitute.

RANDY: Thanks, Collin. That’s great information.

Listen, if you want read more from Collin you can do that in the Insights & Ideas section on Schwab.com. And don’t forget, you can always follow me on Twitter @RandyAFrederick. We’ll be back again. Until next time, invest wisely. Own your tomorrow.

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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. Lower rated securities, such as high yield securities, are subject to greater credit risk, default risk, and liquidity risk. 

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

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Definitions

Bloomberg Barclays U.S. Corporate High-Yield Bond Index the 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.

(1117-7T4H)

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