Investors who have reached for yield in the high-yield bond market might want to consider shifting into higher-quality investment-grade bonds.
The spread between high-yield corporate bonds and Treasuries is below its long-term average, suggesting they may be overvalued, and credit quality may be worsening.
We see more risks with high-yield corporate bonds than investment-grade corporate bonds, with potentially more price volatility through the end of the year.
Investors who have been reaching for yield with high-yield corporate bonds should consider moving up in quality: The case for relatively less-risky investment-grade corporate bonds is currently more compelling than that for their riskier high-yield counterparts.
While high-yield corporate bonds still offer higher absolute yields, that advantage has declined sharply since mid-February, and corporate fundamentals appear to be deteriorating more at that end of the risk spectrum. We also expect volatility to pick up, especially in the riskier parts of the market, in the coming months. Here, we’ll discuss why investors may want to consider cutting back on risker bonds if they’ve been reaching for yield, but don’t necessarily have the risk tolerance to go with it.
A look at spreads
First, let's look at credit spreads in the corporate bond market. This refers to the difference in yield between a U.S. Treasury bond and a corporate bond with a similar maturity. Because corporate bonds tend to be riskier than Treasuries, they generally offer higher yields. The size of the spread is a measure of how much extra compensation investors require to invest in a potentially more risky bond. Normally, that means the higher the risk, the wider the spread.
Spreads are always changing. When they widen, that means yields on riskier bonds are rising relative to Treasuries. That happens when investors grow more risk-averse and require more compensation to hold a corporate bond, pushing prices down and yields up (prices and yields move in opposite directions).
When spreads narrow, that means yields on riskier bonds are falling relative to Treasuries. That happens when investors are willing to accept more risk in exchange for higher returns. That demand pushes bond prices up and yields down. However, if yields on riskier bonds fall too much, it can raise questions about valuations and whether investors are being adequately compensated for the risk.
Where do things stand now?
For investment-grade corporate bonds, the spread is roughly in line with the long-term average, with the average spread of the Barclay’s U.S. Corporate Bond Index now at 1.4%. In our view, that means such bonds appear to be fairly valued.
Investment-grade spreads are roughly inline with the historical average
Source: Barclays. Monthly data as of 9/15/2016. Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used to calculate the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan.
For high-yield corporate bonds, the spread has dropped to more than half a percentage point below the long-term average. From a historical perspective, that suggests high-yield bonds are currently not delivering the kind of benefits they have in the past. In fact, we feel such bonds appear to be slightly overvalued.
Since topping out at 8.4% in February spreads have narrowed by almost three and a half percentage points, with the average spread of the Barclays U.S. Corporate High-Yield Bond Index now at 5%.
But high-yield spreads are 50 basis points below their long-term average
Source: Barclays. Monthly data as of 9/15/2016.
Risks appear more elevated with high-yield corporate bonds
The apparently high valuations of high-yield corporate bonds are just one potential concern. Credit quality is another.
High-yield corporate fundamentals appear to be deteriorating, with issuers beset by disappointing earnings and revenue growth. That could make it difficult for them to service their debts.
Two key metrics of creditworthiness help tell the story. According to Standard & Poor’s, high-yield issuers’ leverage—a measure of debt relative to their earnings before interest, taxes, depreciation and amortization (EBITDA)—has risen for six straight years.1 Meanwhile, their interest coverage ratio—which looks at a company’s EBITDA divided by its annual interest expense—has been declining. Overall, these trends indicate that, down the road, many high-yield issuers may have trouble refinancing their debts as they come due.
By comparison, investment-grade issuers appear to be in much better shape. Their aggregate leverage has remained relatively stable for the past decade, while their interest coverage ratios have actually been rising.2
High-yield leverage continues to rise
Source: Standard and Poor’s. Median debt to EBITDA ratios apply to nonfinancial corporate entities that Standard & Poor’s rates in the United States. It excludes project finance entities and corporate securitizations because of their unique characteristics.
While interest coverage for high-yield issuers has been trending lower
Source: Standard and Poor’s. Median EBITDA Interest Coverage ratios apply to nonfinancial corporate entities that Standard & Poor’s rates in the United States. It excludes project finance entities and corporate securitizations because of their unique characteristics.
Watch for volatility
The recent trends in valuations and credit quality are worth noting because we think volatility may increase through the end of the year. Questions about the timing of the next interest rate hike by the Federal Reserve will likely keep bond yields moving. When interest rates rise, the prices of existing bonds tend to fall, affecting yields. The riskier parts of the bond market experienced large price swings around—and after—the Fed’s last rate hike in December. With expectations for the Fed to hike one more time in 2016, that volatility may resurface through the end of the year.
The possibility that corporate revenue and earnings growth will continue to disappoint could also lead to volatility, underscoring concerns about issuers’ creditworthiness.
Historically, high-yield corporate bonds have experienced much larger swings in prices than less-risky investment-grade corporate bonds because investors tend to shun risk when volatility appears. For an example of how this dynamic generally works, you can look back to the start of the year. In the first six weeks of 2016, high-yield corporate bonds suffered large price declines, delivering a 5.2% loss for the period.3 Investment-grade corporate bonds fared better, offering a 0.7% total return.4
Prices of both investment-grade and high-yield corporate bonds have risen since then, but high-yield prices have gone much further. While investment-grade corporate bonds can underperform when the prices of riskier investments are moving higher, they also tend to be more stable than high-yield corporates during periods of market volatility.
Higher yields usually come with higher risks
Source: Barclays. Yield to worst as of 9/16/2016, and worst rolling 12-month total returns are from 9/30/1996 through 8/31/2016. 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 guarantee of future results.
What to do now?
While price declines may not necessarily matter for investors with long investing horizons, they can hurt investors who need to sell at inopportune times.
Overall, we have a neutral outlook on both investment-grade and high-yield corporate bonds, but we continue to recommend that investors who have been reaching for yield in high-yield corporate bonds but may not have the risk appetite to match should consider moving up in quality to the investment-grade market, especially given the large rally.
1 Standard & Poor’s, “Financial Risk is Rising for Some U.S. Corporate Borrowers as Debt and Leverage Reach Record Highs,” 8/9/2016.
3Source: Barclays U.S. Corporate High-Yield Bond Index. Total returns from 12/31/2015 through 2/11/2016. Total returns assume reinvestment of interest and capital gains. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly.
4Source: Barclays U.S. Corporate Bond Index. Total returns from 12/31/2015 through 2/11/2016.
Talk to Us
To discuss how this article might affect your investment decisions:
- Call a bond specialist at Schwab anytime at 877-908-1072.
- Talk to a Schwab Financial Consultant at your local branch.