Many investors consider corporate bonds to be a safer investment than stocks, which can make it easy to overlook their risk of default—particularly for those rated CCC, CC or C, the least creditworthy. “In 2015, roughly 30% of issuers rated CCC or below by Standard & Poor’s defaulted by the end of the year,” says Collin Martin, a fixed income strategist at the Schwab Center for Financial Research (see “High yield or bust,” below). “Yet there continues to be a robust market for this kind of very risky corporate debt, indicating just how hungry investors are for yield.”
High yield or bust
During the past decade, an average of one in four U.S. corporate bonds rated CCC or below defaulted.
Source: 2015 Annual Global Corporate Default Study and Rating Transitions, Standard & Poor’s.
Indeed, from January 2015 to December 2016, the yield on corporate debt rated CCC or below averaged 14.1%1—five times the yield of A-rated corporate debt during the same period.2 More recently, however, some of these so-called high-yield bonds have failed to live up to their name: Roughly a third of CCC-rated issuers paid yields of less than 7% in January 2017.3 “Some of these bonds are paying half what they might have just last year,” says Collin. “That’s a huge red flag, given their recent default rates.”
That said, Collin believes the outlook for high-yield corporate bonds has recently improved. That’s because the spike in defaults over the past few years was fueled largely by falling gas and oil prices, which have since stabilized. Although the default rate could again drift higher in the next year or two, any upticks will likely be modest. “We’re talking fractions of a percentage point,” he says.
Investors would nevertheless be wise to hedge against the default of any one bond by investing in a fund whose holdings represent a variety of sub-investment-grade corporate debt, says Collin. And all high-yield investors should pay close attention to the difference in returns between high-yield and investment-grade debt. “When that spread narrows,” he says, “investors aren’t getting much compensation for holding riskier assets and may want to look elsewhere.”
The bottom line:
Given the recent rate of default, high-yield investors should ensure they’re being fairly compensated for the added risk.
1Federal Reserve Bank of St. Louis, with data from the Bank of America Merrill Lynch U.S. High Yield CCC or Below Effective Yield Index, 01/02/2015–12/31/2016.
2Federal Reserve Bank of St. Louis, with data from the Bank of America Merrill Lynch U.S. Corporate A Effective Yield Index, 01/02/2015–12/31/2016.
3Bloomberg L.P., with data from the Bank of America Merrill Lynch U.S. High Yield CCC or Below Effective Yield Index.
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