High-Yield Bonds—Extra Income, But Added Risk

by Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research

Key points:

• 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.